Virtu Financial (NASDAQ:VIRT) recently announced that it will be releasing its Q3 results pre-market open on Tuesday, November 7th.
Despite what has been a relatively volatile quarter for Virtu stock, the company has not moved much over the course of Q3, as volatility in the overall asset markets has remained at a historic low.
So, what should we expect from the company when it announces its results in a few weeks?
I. Looking at How Virtu is Making Money
Last quarter, Virtu reported a noticeable, but not devastating, decline in its net trading income year on year due to what it described as "volatility measures globally at historic lows."
(Figure: Virtu Q2 net trading income, Source: Virtu Q2 Announcement)
While margins and EPS declined as well, they still remained at strong overall levels, as did cash, immediate debt obligations, and other balance sheet factors. While the company did only have $160 million in cash on hand relative to $1.6 billion in long-term debt obligations, its short-term debt obligations at the time of the Q2 results were only $13 million.
As trading income through market-making in a variety of asset classes is Virtu's primary source of income, the company's ability to derive profits from its business model relies on volatility in asset prices.
Furthermore, the company is quite diversified in which asset classes it derives its market-making income from. The bulk of its trading takes place in domestic equities, but it also has a significant presence in European and Asian equities as well, for a total of 65.9% of its Q2 trading net income derived from equities.
The rest of Virtu's non-equity earnings are mostly derived from its activities in commodities and currencies. The company also has a small and highly varied market-making business in derivatives, fixed-income, and other seemingly negligible asset classes to its earnings.
II. How Did Those Asset Classes Do?
Domestic U.S. equities have continued to see extraordinarily low levels of volatility, moving little either up or down over the course of this past quarter. Domestic equities even briefly set a 5-decade record low in one volatility measure in early August.
While volatility has not increased significantly in Q3 compared to Q2, it does not appear to have declined significantly more either.
In contrast, it appears that volatility in Europe has increased slightly at a sustained level during Q3.
(Source: Google Finance)
(Figure: Europe VSTOXX volatility index, Source: STOXX)
Asian equities appear to have declined slightly in overall volatility.
Therefore, in the equity environment, based on just volatility, Virtu will likely see decreased trading income from the U.S. and Asia but increased trading income in Europe.
Furthermore, on the commodities side, oil appears to have decreased in volatility.
In contrast, currencies generally saw an increase in volatility this quarter compared to last quarter.
Based on all of this, I estimate that Virtu will see slightly decreased trading income in its domestic equities, Asian equities, and commodities revenue streams, while seeing an increase in trading income in its European and currency revenue streams.
Due to a lack of information available about the composition of its derivatives, fixed-income, and "other" trading category, it is difficult to make a determination on those. However given their relatively small share of Virtu's net income and correlation to other asset classes, they likely are negligible to predicting the company's Q3 earnings.
Based on the above asset class volatility trends, I estimate a slight rise in Virtu's Q3 earnings based on overall slightly increased volatility. Given the company's historically stable trading algorithmic methods, its earnings are highly correlated in a predictable fashion with the volatility of the underlying assets it market-makes for.
Despite the low volatility, Virtu has demonstrated it still is able to make profits consistently in this new environment, even if the profits are lower - and there is no indication at the moment of anything to the contrary. I believe investors will almost certainly receive the company's historically consistent $0.24 per share dividend this quarter as well.
Due to the increases in volatility and increased efficiency of procedures, as well as the still-continuing integration of KCG Holdings, I estimate a small increase in EPS from its Q2 $0.13 per share to roughly $0.15 a share. Based on the roughly 35 P/E ratio at the moment, that comes to a valuation of $21 a share.
Virtu's P/E ratio has been quite high, especially compared to the rest of the capital markets industry (about 20 right now), but justified to a degree by the premium it commands due to its high potential to continue make innovations in the market-making and trading industry.
It looks like the company will be having a slightly better quarter than the last one due to the increased volatility, albeit still waiting for volatility to really begin picking up at a sustained level.
The integration of KCG Holdings and expansion into other asset classes for market-making also look to be promising and worth watching.
Disclosure: I am/we are long VIRT.
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.