Can Knight Capital Find A White Knight?

| About: KCG Holdings, (KCG)

Knight Capital Group (KCG) is imploding after yesterday's trading "glitch". Today the company anounced that the total pre-tax losses from the errant algorithm were $440 million. In the press release, the company indicates that it's capital base has been "severely impacted" and that it is "pursuing its strategic and financing alternatives to strengthen its capital base." Knight's CEO, Thomas Joyce, went on TV and defended the firm saying the company "has excess capital right now".

This all begs the question - can Knight find a buyer? We believe the answer is probably "no".

Knight has 4 reporting business segments: (1) Market Making, (2) Institutional Sales and Trading, (3) Electronic Execution Services and (4) Corporate and Other. According to their latest 10-K filing, the Market making segment constitutes the bulk of both revenues and profits for the firm. Below is the breakdown of revenue and profits by segment from their 10-k:

Segment Revenues ($ millions) Profits ($ millions)
Market Making 704.5 256.1
Institution Sales & Trading 511.5 (44.4)
Electronic Execution Services 167.9 49.5
Corporate & Other 20.6 (74.1)

The trading "glitch" occurred in the Market Making business segment. The old adage in trading is "You're only as good as your last trade". Indeed, reading their 10-K regarding their lines of business and how they intend to compete in the marketplace, it is clear that Knight has staked its reputation on "sophisticated trading algorithms" and "high speed of execution". These are the very things that caused them to vaporize $440 million, and with it possibly their reputation, in less than one hour.

Balance sheet problems aside, the viability of the business franchise is in question here. As a potential suitor/acquirer, on what basis would one value the KCG franchise? They freely admit that:

Over the past several years, regulatory changes, competition and the continued focus by regulators and investors on execution quality and overall transaction costs have resulted in a market environment characterized by narrowed spreads and reduced revenue capture. Consequently, maintaining profitability has become extremely difficult for many firms. Generally, improvements in execution quality, such as faster execution speed and greater price improvement, negatively impact the ability to derive revenues from executing client order flow. For example, we have made, and continue to make, changes to our execution protocols and quantitative models, which have had, or could have, a significant impact on our profitability.

In other words, they are finding it harder and harder to make a profit by churning shares for pennies per transaction. If the clients who trade through Knight decide that executing elsewhere carries less potential risk, Knight may be facing increased costs to acquire order flow that ultimately proves unprofitable.

Entrenched players who compete with KCG for the market making business do not need to acquire them, they know they will get the order flow once Knight is out of the picture. The dynamics of the high frequency trading business do not seem conducive to a new entrant stepping in by acquiring a firm that just made a huge blunder. As noted by Jacob Bunge in this Wall Street Journal peice, private equity firms seem to be moving out of deals in the space.

Given that their largest and most profitable business segment's reputation has taken a hit, and that reputation is the basis for firms to be able to participate in a market, we see little incentive for an outside firm to act as savior for KCG.

The electronic execution services business segment may have some value as a stand alone entity, but it is unclear without a more detailed analysis whether or not this unit has enough scale to stand on its own.

Within a day or two we will know whether or not institutions are comfortable to continue to do business with KCG. Knight's CEO publicly states that he aims to keep the firm's business alive, which is really the only thing he can say in this situation. Ultimately, the future viability of Knight's market making business segment is in the hands of its clients, not its CEO.

Our view is that the trading "glitch" has done irreparable harm to the business franchise and the company. Investors considering buying in to KCG due to it's reduced price would do well to wait until the dust settles regarding whether or not they can obtain the financing to shore up their capital base. The "exploring strategic options" line in KCG's press release should not be given too much weight in our view since bankruptcy is just as much a "strategic" option as is a sale of the company.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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