Knight Capital Group: A Cash Heavy, Unleveraged Financial Play

Note to investors: This week’s recommendation is a revisit from the deep freezes of January 2007, when the stock was at $19. Yes, we have been wrong for so long on this stock, we’re about to be right. We brought these shares out of the icebox to thaw out in the 90 degree temps of summertime. It’s a table pounding buy now, and yes, we still own it and bought a large position in it last week. There is so much value here, the Company is buying back 40% of itself with its own cash. This stock’s not going to be frozen much longer.

Knight Capital Group, Inc. (NITE), together with its subsidiaries, provides trade execution and asset management services in the United States. It operates in two segments, Asset Management and Global Markets. The Asset Management segment operates as an investment manager, as well as sponsors hedge funds. This segment primarily serves institutions, funds-of-funds, pension plan sponsors, trusts, endowments, and private clients. The Global Markets segment provides a range of customized trade execution products and services across various asset classes for broker-dealers, institutions, and issuer companies. This segment’s institutional products comprise trade execution solutions, block trading, program trading, international equities, special situations/risk arbitrage, soft dollar and commission recapture programs, corporate services, technical research, and direct market access. Knight Capital Group was founded in 1995 under the name Knight/Trimark Group, Inc.

In laymen’s terms, Knight functions as a market maker, providing liquidity in the daily stock markets, and maintaining an orderly flow of trading in individual stock names as the buyer and seller of last resort. Knight also manages the Deephaven family of funds, which are internally managed single strategy hedge funds and funds of funds that collectively oversee over $4.2 billion in assets.

This asset management business has been somewhat of the growth engine underneath Knight Capital Group’s “market making exterior”. In the most recent quarter, ended June 30, 2007, management fees from the Deephaven asset management group grew, according to the company to a level of $29.1 million, or an annualized rate of $116 million. Total revenue to the Company for the quarter was $201 million in the quarter, fairly flat compared to the $205 million in total revenue in the same period one year ago.

Balances in the Deephaven funds grew to a level of $4.2 billion according to the Company, up from $3.1 billion in the June 30, 2006 period. This development underscores the transformation of Knight Capital from a traditional market-making house into a diversified financial company.

Interestingly, as a market maker, Knight operates in a segment of the market that has seen remarkable consolidation within the last few years. With the public issuance of stock, groups like the New York Stock Exchange have had currency to begin acquiring various other electronic exchanges, entering the battle for the acquisitions of other exchanges such as Instinet and Archipeligo. This consolidation is a trend that will continue, as the larger exchanges grow by swallowing their smaller rivals. Knight Capital Group, as a market maker, stands to potentially be acquiried by these exchanges as they seek to build efficiencies within their various market segments. An event such as an acquisition is outside the realm of this particular fundamental analysis effort and recommendation, but is significant to note in terms of an industry trend that could impact this company’s future.

Sum of the Parts: Returning to the fundamentals, Knight Capital Group’s balance sheet is currently a cash-heavy, unleveraged situation. Current cash on the books at the end of June 2007 is $565 million, offset by ZERO long term debt. This leaves NITE with over $5 per share in cash on hand. If that cash value is backed out from the current stock price of $14.00, that leaves an economic value of NITE shares at roughly $9 per share in today’s market. We feel this is much too inexpensive for a diversified company with an asset management subsidiary overseeing $4.2 billion, (which throws off in excess of $116 million per year in fee revenue on an annualized basis) and a strong stream of market making revenue. Looking strictly at the asset management business, that is a revenue base of over $1 per share on that $9 economic value of Knight. Should the Deephaven funds ever be either sold off or acquired (Morgan Stanley recently acquired interests in three hedge fund groups) we estimate that the value could be for 4x to 5x that revenue stream, or $500 million to $600 million in value, fully $5 to $6 per NITE share.

This analysis implies that the global market making business, currently throwing off over $160 million in quarterly revenues, and $32 million in quarterly profits (or nearly $650 million annually in revenues and $120 million in profits - - equating to $6.50 per share, in annual revenues and over $1.20 per share in profits) is essentially being valued at around $4 per share. Yes, that’s a Price to Earnings ratio of 3x.

Looking forward, the group of eleven analysts who cover Knight Capital Group have a consensus estimate of $1.06 in EPS for Knight Securities this year (ending December 2007), with the earnings estimate actually declining from the actual results from last year (ending December 2006) which came in at $1.36.

Within the last year, the December 2007 earnings estimate has been revised downward from a level of $1.31 per share one year ago to that $1.06 level today. We would expect some level of upward revision to the 2007 year-end estimates if the volume levels in the US Exchanges continue setting new all time trading records as they did this week. While there is a limited amount of seasonality to the earnings cycle of this company, the growth of asset management fees, which are more stable, would tend to counter any future blips. Continued strong returns in the Deephaven Funds will place the Company in a competitive position to add to its asset base in the near future, continuing the growth trend at the overall Company.

A Mammoth Buyback: With its latest earnings report (july 18th), NITE also mentioned that its Board of Directors has approved a new $505 million buy back program, effectively looking to purchase what amounts to (at today’s values) around 40% to 50% of the Company. Clearly, if you want to buy NITE shares, you better hurry. In five years, this Company will have taken itself private. Of interesting note this week was that as markets were selling off Thursday August 9th and Friday August 10th, NITE was up or at break-even all day. If you wonder who was buying the stock, I don’t think you would have to look very far to see the most likely candidates. There aren’t many stocks trading this cheaply, and management has realized it.

NITE Chart Review

Technical View: NITE’s price has declined about 20% on a “sell the news” type of a reaction after their earnings in Mid-July. Cynics amongst us can wonder if the “miss” they posted by 2 or 3 cents was designed to get the share price down for their buyback.

At present levels of around $14.00 per share, both the MACD and the RSI reflect a bottoming in NITE’s share price. This gives opportunity in the shares of this fundamentally strong, growing company, and also contributes to a volatility premium in the near-term options expirations.

Investment Recommendation: We recommend that investors accumulate NITE shares at or below $14.00 per share, with a target exit price of $22.00 per share. This valuation is based on a market multiple of 2x to 2.5x of NITE’s $9.22 per share book value, averaged with a multiple of earnings of 18x to 20x. On a premium valuation, NITE could be worth up to $30 per share if it were the subject of an acquisition.

Option trade suggestions: Our written put strategy calls for investors to sell, or “write” the September, October 2007 and January 2008 expiration put options on Knight Capital Group at the $12.50 strike price. (See the written puts array on next page for dollar value and position analysis). The final price an investor will pay is dependent upon how many of the options are assigned over the life of the position and the transactions costs.

Long Call suggestion: We would look to purchase the September and October 2007 and January 2008 $15 strike Call options at the present levels of $0.75, $1.10 and $1.70, respectively. We would look to exit those calls when the stock trades above $18.00 or higher.

Long Stock / Short Call suggestion: Buy the shares of NITE at $14.00 or lower, look to write covered calls at the $20 strike price when NITE’s price passes $18.00 per share.

Disclosure: author manages a Fund that is currently long NITE shares, and short NITE puts.

Comments

[rich riker]

I don't see the market making portion of the firm as an acquisition of an exchange. They may have an interest in the Direct Edge ECN, though that interest may not be on Knight's side considering the recent announcements about it.

What portion of the cash you mentioned is free and what portion is regulatory capital tied to the Market making business? Also, does their hedge fund manager have any of the strategies that caused the losses at some of the quant funds? Finally, what was the catalysis for the stock's recent sell off.

[wfock]

Are you including "securities owned, held at clearing brokers" as part of their cash balance? I believe that is really just part of their market making operations and not "cash balance". If this is true, then their true cash on the balance sheet is more like $125.6MM vs. your estimation of $565MM... Having said that, I am no expert on NITE and could very well be wrong.