Knight Capital Should Drop, Bounce Following 8-K Filing

Aug.28.07 | About: KCG Holdings, (KCG)

Banc of America notes that yesterday, they sat down with Knight Capital Group's (NASDAQ:NITE) CEO Tom Joyce and CFO Steve Bisgay. Mgmt was up- front about pressures NITE feels in both core business and Deephaven currently, but continues to believe NITE is well-positioned for long term. Current valuation (10x '08E ex. $3 cash per share) appears to reflect challenges, but given time it may take for cyclical pressures to abate and/or positive elements of story (increased share buyback) to impact EPS, investors likely need patience here given lack of near-term catalysts. Still have long-term positive view on NITE given valuation, but cognizant of near-term challenges ahead.

In 8-k last night, NITE stated that due to mkt conditions/industry practice, that if a Deephaven fund incurs losses in 2H07, NITE would return a portion of 1H07 incentive fees ($68.4m). Based on BAC's meeting, issues seem related to event-driven fund, which along with mkt. neutral fund accounts for 85-90% of AUM. Although unclear what EPS impact will be in the end (depends on extent of losses, performance in 2H07 and compensation offset), they expect NITE to face significant pressure today (and wouldn't be surprised if mkt over-reacts to announcement).

Reducing estimates to take into account Deephaven issues and more cautious outlook on core Global Markets business. 07/08 estimates go to $0.96/$1.15 from $1.06/1.33. Maintains Buy due to valuation.

Notablecalls: I'm sure NITE stock will get hit today following the 8K filing released last night. Yet, it looks like most of the problems are related to Deehaven's event-driven fund that accounts for less than 35% of assets under management. I also think the root of the problem is the recent turmoil in the credit mkt (widening spreads), which makes the problems s-t in nature.

BAC notes that in discussions with management after the 8-K was released, the company stressed that Deephaven was not blowing up, but that the 8-K was to clarify the clawback provision given current market conditions. This seems to confirm my views. Also, due to the recent major market moves of late, NITE appears to be feeling pressure in the broker-dealer business.

BAC's new EPS estimates assume no contribution from Deephaven in H207, which may prove to be pretty conservative. The pressure in the broker-dealer and ALP side remains an unknown variable but I don't see any disasters there. The algorithms have likely underperformed but will rebound eventually as the market becomes more stable again (it has already, btw).

So, all in all I think the stock should become buyable for a bounce today. I'm guessing around recent lows, say $12.50-$13 level.