Get Long Vol With Virtu Financial Going Into Q1 Earnings

Summary

• A consistently profitable business model with the benefit of increased profitability during market uncertainty makes it an ideal hedge to diversify a portfolio.
• The company will report Q1 earnings on May 4th, 2018. Trading revenues and EPS are expected to be significantly higher due to increased global volatility since early February.
• Continued expense synergies from KCG Holdings acquisition and lower income tax rate should ensure record profits for the quarter.

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Introduction

After a very slow and steady climb in global equity markets throughout 2017, we have now finally begun to see a return to more normal levels of volatility. Investors had been warned about the lengths of previous bull market cycles, pending geopolitical events, climbing debt levels, and inevitable downturns in the business cycle and onset of recession. But they were able to look past all this because the uptrend in markets seemed so strong. US tax reform was being passed. Janet Yellen was up every couple of months to remind us that everything was to be gradual and data-dependent. The phrase "blow-off top" was being used to describe a final phase of euphoria to come, with the FANGs leading the way. But things have evolved. Since the beginning of February, we have seen a return to more normal levels of volatility, and the markets have stopped their relentless upward climb. US quantitative easing has turned into tightening, ECB and BOJ are reducing stimulus, debt levels are still high, and we have a new Trump tweet every couple of hours to remind us of new potential tariffs and how trade wars can be won. Coming into Q1 earning season, markets have been chopping around waiting to see how these events play out. Is the bullish trend still intact with markets to move higher, or will we drop below the 200dma and retest our lows? It's impossible to know what the future holds, but what we do know is that markets do fall, and recessions do happen. It is nearing a decade since it last happened. Now is an important time for investors to position their portfolios to reflect this increase in risk and uncertainty with hedges that will outperform in the event of a downturn. This article will present a company that should do increasingly well in this type of volatile environment and should be considered by investors to hedge potential losses in the broader markets.

Company Background

Virtu Financial (NASDAQ:VIRT) is a leading financial technology company that provides market-making and trade execution services in over 25,000 securities, at over 235 venues, in 36 countries worldwide. On an electronic trading exchange, a market maker is licensed by the exchange to offer continuous liquidity by selling to buyers, and buying from sellers, in micro-fractions of a second, millions of times a day. This liquidity is beneficial to all investors as it provides an opportunity to trade at very near to the actual last quoted price at any given time, thereby reducing risk. Without which, in times of panic, people looking to sell would have nobody on the other side of the trade to sell to and would have to accept a drastically lower price in order to incentivize a buyer to step in. Market-makers provide this service to both buyers and sellers. Their profit comes from the bid-ask spread, or the difference between the price a buyer is willing to offer and the price that a seller is willing to accept.

Virtu's superior technology, both physical hardware and trading algorithm software, allows them to recognize and offset these trades against each other, pocketing the spread on each trade. The more volume that is traded, the more income is earned. The business model has been consistently profitable. CEO Doug Cifu got into a bit of trouble during the roadshow before the Virtu IPO by letting slip that the firm had only had 1 down day in 5 years of trading from 2009 to 2014. This was around the time that the Michael Lewis book 'Flash Boys' was being promoted and made high-frequency traders (HFT) and algorithmic strategies seem to be nefarious shadows, operating in dark pools, cheating the average retail trader. In actual fact, Virtu has been very outspoken about increasing transparency in markets and has worked closely with regulators to that end.

The firm was created by a former New York Mercantile Exchange Chairman Vinnie Viola, and is now chaired by ex-Nasdaq CEO Bob Greifeld. Very public figures that are well known in the industry with connections to all levels of government, market exchanges, and regulators. They are very well-positioned to work together to ensure the smooth functioning of the increasingly automated and high-frequency nature of markets today. While many other hedge-funds and HFT firms have been forced to close down and return capital to investors due to these technological changes, Virtu has been able to position itself as one of the premier firms to capitalize on this evolution.

Changing Market Dynamics

In periods of heightened volatility, bid-ask spreads will widen somewhat to compensate the market-maker for the increased risk of holding the position and having the price move against it before it is able to offset the trade. These periods also usually correspond with increased trading volumes allowing for more potential trades to be executed by the market-maker, further increasing profitability.

As can be seen in the chart above, and is generally realized by most market watchers, 2017 was a period of record low volatility as the market slowly trended higher over the course of the year. The period corresponded with daily conversation highlighting the amount of time passed without a 10%, 5%, or even 3% correction. Even a daily move exceeding 1% was notable. Short-vol and buy-the-dip were the principal themes for 2017. However, beginning in February of 2018, we saw a return to normal levels of both volume and volatility. After an initial spike shaking out many of those invested in short-vol products, daily moves in the major indexes have remained elevated to the upside and downside. Uncertainty has returned.

As explained above, this increase in volumes and volatility will result in much greater trading revenues for Virtu's market-making and trade execution services. Their algorithms are designed to take the pulse of the markets in real time to capitalize on the heightened trade flow while effectively managing risk. Unlike many other HFT proprietary trading funds, Virtu does not place trades betting on market direction. Their risk management strategy will offset a hedging trade elsewhere, often with derivatives, to remain neutral regardless of direction. This ensures consistent profitability going forward, and that has already been seen in recent earnings.

Q4 2017 Earnings Highlights

Virtu was able to surprise to the upside in Q4 2017 with $0.22 EPS (estimated $0.12) on revenue of $460.42M (up 169.8y/y), including $237.3M in net trading income (up 38% over Q3), despite record low trading volumes. The earnings beat was largely due to continued progress made in the recent acquisition of KCG Holdings on April 20, 2017. Merging of the two market-making models has allowed Virtu to realize $177M of gross annualized run rate savings through Q4 without adversely affecting net trading income, and has guided for total run-rate synergy savings of $250-275M in FY2018 and $300-315M in FY2019. The savings mainly coming from routing all previous KCG trade flow through Virtu's proprietary computer technology, reducing headcount (compensation) in redundant positions globally, and streamlining backoffice overhead, as well as greatly reduced duplicate data feed and processing costs. They have also leveraged KCG's much larger institutional sales force, which greatly increased their own expertise in this area. It allows Virtu to showcase their technology platform to other institutional clients and offer corporate trade execution services, thereby increasing and diversifying revenues. These synergies are expected to continue in 2018.

Another area of cost savings going forward will result from recent tax reform in the US. Prior to legislation, Virtu paid an effective pro forma rate of 37%, which is estimated to be reduced to 23% on the firm's earnings on North American business. Virtu also operates in low-tax Dublin, Ireland, for EMEA operations and in Singapore for Asian operations.

Upcoming Q1 2018 Earnings Report

Upcoming Q1 earnings on May 4, 2018, will be interesting to see exactly to what extent Virtu is able to capitalize on these increased global trading volumes on the top-line revenues and how it will affect the bottom line. Analysts expect Q1 earnings per share to come in at $0.52/share. (up 225% y/y)

Source: Yahoo Finance

With an average revenue prediction Q1 of $288.31M (up 250% y/y)

Source: Yahoo Finance

These figures have been revised up significantly in recent weeks due to increased volatility, as can be seen below.

Source: Yahoo Finance

An additional item of interest in the upcoming Q1 release will be whether the firm makes any surprise modification to its dividend policy or stock repurchase plan. The company currently has trading capital of $1.313B as of December 31, 2017, and has stated that its estimate of trading capital required to operate Virtu market-making and Virtu Execution services is only $750-850M, resulting in an excess of $463-563M. It has committed to debt repayments through 2018 of $240M but is still left with roughly $223-323M excess capital as well as expected elevated future profits. It may choose to return capital by increasing its current $0.24/quarter dividend or increasing its recent $50M share/unit repurchase program.

Valuation

A precise valuation of Virtu's business model is difficult because the nature of its trading revenues is uncertain, dependent on aggregate volumes traded on global exchanges. But with volumes returning to historical norms, if we project the current 2018 average annual EPS estimate of $1.80/share and give it a 20x P/E multiple due to industry, growing revenues, share buybacks, a $0.96/year dividend, we arrive at a share price of $36.00. This is roughly where the stock trades today. But we could see continued upside if global trading volumes remain elevated and EPS estimates are revised upwards. At the very least, knowing that with low fixed operating costs, Virtu was consistently profitable, while paying a dividend and buying back shares, throughout the record low trading seen in 2017. It gives a sense that the firm can perform well in almost any trading environment.

Conclusion

As can be seen, Virtu's share price has recently risen due to strong Q4 earnings release and increased earnings expectations resulting from recent uncertainty and heightened trading volumes. But the company's consistently profitable business model should continue to reward investors and can be used as the perfect 'long-vol', 'antifragile', portfolio hedge to provide excess returns when the wider markets are falling. Two-way markets have returned in 2018. Virtu is poised to capitalize.

Conviction Buy and Hold.

Analyst’s 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.