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Knight Capital Group's (NYSE:KCG) trading debacle on August 1, 2012, cost the firm $440mm, wiping out their total cash position, and then some. Since then, the firm has secured a $400mm financing from a group of firms led by Jefferies (JEF) ("the group") to save the firm. The terms of this financing allow the group to buy 267mm shares of the company at $1.50, taking the outstanding shares from 98mm to 365mm, and allowing the firms to buy Jefferies at a 50% discount to closing price on August 6, 2012. On the heels of this announcement, KCG resumed its normal operations, and announced that many of its customers scared away by its current crisis have returned their business to the firm. The question now turns to you: Should you follow the lead of Jefferies and KCG's customers, and invest in the company?

The Next Few Days

The group will convert their preferred shares into common shares over the next 10 days. During that time we will get a better sense as to where the stock price will land. Presumably, it will continue to decrease from its current levels, so you should wait and see where the share price lands.

When The Dust Fully Settles

After the group converts their shares, and we have a better picture on the final price post-dilution share price, investors could end up with a steal. Consider the following: KCG has essentially landed on its feet in the same financial position as it had pre-crash, albeit with a tripling of their equity base. It depleted all of its cash with the loss, and has replaced it with new cash. Therefore despite the accounting treatment of its $440mm (~$250mm post tax) loss, which will force it to recognize losses for the rest of this year, and probably into the next, you can ignore that fact, and examine EPS ex that loss.

As we said above, post dilution, KCG will have 365mm shares outstanding. Analysts estimate that KCG will post $122mm in net income over the next two years, or 33 cents a share, post dilution. Assuming KCG doesn't suffer a permanent impairment from its debacle, those estimates should stay relevant.

At the current price, and assuming analysts estimates, KCG would give you a 10% return on equity over the next two years, with that return increasing if the stock continues to fall in price. Compare this to its purest competition, Interactive Brokers (NASDAQ:IBKR), which gives you a 8.6% return based on August 7, 2012 closing. Frankly, comparing KCG to IBKR using this metric, does not give you much encouragement to buy the stock. However, I have laid the framework for you, and if the price continues to fall, and that return starts to hit 15-20%, the stock could become much more compelling.

Other Considerations

Even assuming the price gets down to a point where you feel confident that you will see a nice return, you still must consider some meta issues.

MF Global -- not too long ago, we saw the downfall of another market maker -- MF Global.

Obviously, the two situations have their differences, but I think you can pick out a common thread. Namely, firms like MF Global, and Knight Capital, operate in a business where they handle huge amounts of capital, and because of their size, do not have the ability to absorb losses in the same way other firms that traffic in the market making space can.

The Exchange business has been in flux for a while with a bunch of messes:

  • The Facebook IPO
  • BATS IPO
  • Flash Crash

I am not trying to imply a connection between any of these events, and the problems in one might not apply to another. But I think that those parties involved in the execution of trades might get a little ahead of themselves sometimes in terms of their reliance on technological advances, and not operate with the utmost caution. Basically, as trading technology continues to advance, we could see another event similar to this, and the financing markets might not shine their faces as readily as they did in this case.

Conclusions

Thomas Joyce has successfully navigated this extremely difficult period in the company's history with his reputation for honesty in tact. He threw his firm in front of the moving train on August 1 and absorbed all of the losses from the erroneous software glitch. He then secured a life saving financing round that ensured the company's ability to operate as a going concern. He has shown himself as an effective leader not only by instilling a deep sense of customer loyalty in his company, but by rallying the industry around himself to ensure his company's survival. If these actions serve as any indication as to Mr. Joyce's capabilities, KCG could move past these events, and on to a strong future.

Source: Knight Capital: What's Next