By The Valuentum Team
Virtu Financial (NASDAQ:VIRT) provides market making liquidity services to financial markets around the globe; the firm ended 2015 with its global technology platform connected to over 230 unique venues in 35 countries. The performance of the firm's six segments (American Equities, Global Commodities, Global Currencies, EMEA Equities, APAC Equities, Fixed Income and Other Securities) delivered record performances in 2015 in terms of adjusted net trading income and technology services revenue and adjusted EBITDA, showcasing the diversity of its business.
Perhaps the biggest challenge for Virtu is the stigma surrounding high frequency trading, which many regulators are still working to gain a better handle of. For example, the firm was recently punished by French regulators for the actions of one of its subsidiaries related to order-to-trade ratios. Also, a great deal of its performance is beyond the company's control. Revenue and earnings generation depend on trading volume and volatility in the markets in which Virtu operates, making performance difficult to predict.
Virtu's scale and largely fixed cost operating structure give it attractive margin potential. The firm's total operating expenses are typically ~35% of total revenue, and its business is not a capital-intensive one. Looking forward, technology increases will further improve its operating efficiency and growth potential, as the ability to add new products or locations at minimal marginal costs increases. Ongoing concerns over the geopolitical environment and uncertainty surrounding interest rates across the globe are expected to drive demand for Virtu's liquidity services in the near term.
Virtu Financial's Investment Considerations
- Virtu Financial provides market making and liquidity services to inancial markets around the globe. The firm's technology platform rovides quotes to buyers and sellers across a wide range of asset classes on various exchanges, markets and liquidity pools. The ompany was founded in 2008 and is headquartered in New York, New York.
- Virtu has significant scale and its cost base is largely of the fixed variety, which helps it drive attractive margins. The firm's business model is asset light and little capital expenditures are needed for maintenance.
- Virtu is diversified across markets and geographies, and volumes and volatility across these markets and geographies are what drives adjusted net trading income. Normal volumes are augmented by exogenous events. Such events include scheduled events such as central bank policy, earnings, statistical releases and election and unscheduled events such as global unrest, credit downgrades and major market moves.
- Drivers of Virtu's growth moving forward include the aforementioned events, geographic and asset class expansion, growth in accessible and addressable opportunities in existing markets, and improved capturing of revenue and increased penetration of existing markets.
- Open and transparent markets favor Virtu over legacy market structures, meaning regulatory change creates opportunity for Virtu. Transparency, credit intermediation, and technological prowess are potential competitive advantages moving forward for the firm.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Virtu Financial's 3-year historical return on invested capital (without goodwill) is 16.8%, which is above the estimate of its cost of capital of 9%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
The concept of an economic moat - or sustainable competitive advantages - focuses purely on the sustainability and the duration of the competitive advantages that a firm possesses. The concept of an economic moat does notconsider the cumulative sum of a firm's potential future economic profit creation, but only that at some point in time in the future, a moaty company will continue to have an economic profit spread and a no-moat firm will not.
Let's examine the problem that arises by focusing exclusively on companies that have economic moats, or sustainable and durable competitive advantages.
Image Source: Valuentum
In the chart below, we show the probable path of Virtu Financial's ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Virtu Financial's free cash flow margin has averaged about 28.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Virtu Financial, cash flow from operations increased about 32% from levels registered two years ago, while capital expenditures fell about 26% over the same time period.
In the first quarter of 2016, Virtu Financial reported cash from operations of ~$51 million and capital expenditures of ~$1 million, resulting in free cash flow of ~$50 million. This represents a 36% decrease from 2015.
This is the most important portion of our analysis. Below we outline our fair value assumptions and derive a fair value estimate for shares.
We think Virtu Financial is worth $32 per share with a fair value range of $23-$41. Shares are currently trading at ~$18, below the lower bound of our fair value range. This indicates that we feel there is more upside potential than downside risk associated with shares at the moment.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
Our expectations for 2016 revenue are slightly more generous than consensus estimates, as we are forecasting the firm's top line to decline marginally from 2015 levels. We anticipate strong earnings growth in 2016 as uncertainty surrounding global interest rates remains and a volatile geopolitical environment continues. Trading volume and volatility are drivers of trading income. 2017 is expected to be a strong year for the company in terms of revenue and earnings growth.
Our model reflects a compound annual revenue growth rate of 3.7% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 6.2%. Our model reflects a 5-year projected average operating margin of 34.2%, which is above Virtu Financial's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 1.5% for the next 15 years and 3% in perpetuity. For Virtu Financial, we use a 9% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $32 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Virtu Financial. We think the firm is attractive below $23 per share (the green line), but quite expensive above $41 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Virtu Financial's fair value at this point in time to be about $32 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Virtu Financial's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $40 per share in Year 3 represents our existing fair value per share of $32 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.