Virtu Financial: Providing Value And Downside Protection

Summary

• Virtu is one of the biggest market-making and execution services platforms.
• Volatility which has been subdued in recent times, may arise in the future, which would in turn benefit Virtu’s business model.
• A strong balance sheet and improving revenue, with continuously improving margins make this a fundamentally sound company.

About Virtu Financial

Virtu Financial (NASDAQ:VIRT) is one of the largest providers of financial products, trading, and market-making services. Its services include execution, liquidity sourcing, analytics, and broker-neutral, multi-dealer platforms technology. It provides quotes on equities, commodities, currencies, options, fixed income, and other securities, for over 230 equities, markets, and dark pools. It provides execution services in over 50 countries. The company executed over 1.27 billion of order flow for customers in 2020, which included $621 million in notional trades.

Investment Thesis

Virtu is expected to continue to witness revenue flow, both as a market maker and from its range of financial products. The company continues to provide execution services globally, and the investment cycle should help to push revenues higher going into 2021. As the company continues to improve revenue, it has also reduced debt, meanwhile continuing its buyback of shares, which only serves to further improve its bottom-line. Also, one of the most important facets is that the company would benefit from a market crash and this could be a great hedge against long-term volatility using non-traditional positioning.

Low volatility environment

Virtu Financial has continued to perform well in an environment where volatility is low. Because it provides a range of services that benefit from volatility, including downside protection, the company is strongly placed to gain from any increases in volatility. The historically low volatility is unlikely to continue, as more and more liquidity in the markets continues to push assets to ever richer valuation, thereby increasing risk.

Retail investors will help to improve revenue across the business

Retail investors have become a larger share of total trading. This serves well for both volatility and execution volume. Throughout 2020, increased participation has been quite lucrative for the business. Average adjusted daily net trading income came in at $9 million for FY20, up significantly from the previous year.

(Source: Investor Presentation)

Virtu Execution Services (VES) remains key

Virtu execution services that provide over 40+ product to global asset managers, has benefited significantly from Virtu’s merger with ITG. Currently, a third of the clients utilize multiple products, this means there remains a significant opportunity for both expansions of cross-selling and finding new clients to onboard. I expect the trends from 2020, of improved cross-selling and the bringing on of new clients to continue into 2021, as management continues to focus on execution and products to bring in more revenue. VES, which brought in over $135 million in net trading income in 2020, could see significant improvement in 2021 should management execute.

Margins are improving and debt has been reducing

Management continues to retire debt and find a way to improve margins. Long-term debt was reduced by $288 million to $1.64 billion. With over cash on hand around $2.45 billion and FCF of $1 billion, should help the company continue to bring down debt during the year. By focusing on expense discipline the company was able to achieve an EBITDA margin of 73% in 2020. Although I expect CAPEX will increase in 2021 as the company continues to focus on improving products, which may weigh on the bottom line. Cash and compensation ratios 14% and 16% for the year, and should stay similar or see slight improvements going into 2021. What is important to note is that the fourth quarter saw EBITDA pushed to 75% and could continue upwards into 2021.

Risks

• Market Making requires risk capital, should execution not be up to par losses could occur on the order book.
• Volatility and organic demand remain key to revenue, if either of these gets depressed the company could witness a fall in revenue.
• Inability to provide liquidity for whatever reason may result in clients switching out of Virtu’s services.

Opportunities

There remain opportunities both in the options market making and retail trading. Both these could be lucrative should the company choose to increasingly pursue these markets. The company could also expand internationally and this would bring in a whole host of new revenue streams. Internationally the market making and product-based services remain underserved and this would provide the perfect opportunity for the company.

Virtu Metrics and Valuation

The company trades at a relatively cheap valuation and has high levels of efficiency. With a return of equity of 34% and a P/E of 6.5, the stock continues to trade at levels that are very cheap compared to the broader market. The low valuation could stem from the volatility in earnings, but within improved execution, the risk remains relatively lower. Meanwhile, the continued expansion of business should help revenue continue to climb over the coming years. Price to book of around 2.86 is also relatively low compared to peers.

When using a WACC of 8 and a terminal growth rate of 0, with a growth assumption of 10% over ten years, would put the company's valuation at $65. This would imply an upside of over 100%. Clearly, the stock is depressed, and I believe there remains a lot of value to be had.

Conclusion

Virtu remains a value play that is witnessing the benefits from its range of market-making products. Since it offers downside protection through volatility-based products and the increase in retail involvement combined with generally higher trading volumes, means the company is well poised to move forward. Furthermore, the stock trades at a discount to intrinsic value, and while risks remain, due to historical volatility in earnings, the business model is becoming more and more lucrative, which should reduce some of that risk.

Analyst’s 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.

Comments

[usera2020]

Can you explain how they make money when the market falls and thus downside protection?

[inv28758231]

@usera2020 from what I understand they do algorithmic trading. Since they are neither short nor long, they don't care about the direction of the market, as long as volatility is sufficient for their trading bots to function.

[Jozsef]

@inv28758231 they can create and destroy ETF's. So if shares are cheaper they buy shares and sell ETF. If shares are more expensive they sell shares and buy ETF.

The more stress in the market the wider the price gap hence more margin.

[chimcentral]

@usera2020 when the market drops, volume picks up; higher volume means companies like this buying at bid, selling at offer, a lot more - translates to higher profit.

[inv28758231]

Thanks for the article. A couple of thoughts:
1) VIX has stayed above 20 since March 2020. This is much higher than the historical average. It is possible that we are in a new regime.
2) A P/E of 6.5 is not a reasonable metric to value the company, since that reflects an abnormally high volatility period. Looking further back and seeing how the company performed in previous times would be more reasonable. That said, I still find the current stock price attractive.

[Leviathan1]

@inv28758231 Agreed. 2020 numbers obviously cannot be extrapolated forward and used as a base for a valuation model. The key questions that need to be answered about VIRT are:

1) What is the run-rate earnings that Virtu can generate once the volatility environment normalizes? Are we to believe management that $2/per share is the new earnings "floor"? There is evidence of at least some real secular tailwinds that should persist even after the cycle has normalized (i.e. retail involvement, market making in new verticals). It would really be helpful to understand what exactly changed for Virtu over the past 12 months that would account for earnings generation doubling from $1 to $2.

2) How long will the present favorable environment last and how much excess earnings can Virtu generate over that time period? I was very surprised at Virtu's commentary that the first 6 weeks of 1Q21 were comparable to 2020 results ($9m/day of ANTI). If this environment lasts through 2021 and '21 results are similar to '20 results, value would increase by $4/share (which is the approximate excess return generated in '20).

3) What is the risk of regulatory changes hurting Virtu's business model? If there is a ban on payment for order flow, will Virtu suffer? Should we believe management that such a regulation wouldn't make much of a difference? Perhaps this regulation would be favorable to Virtu because it would cut their expenses and wouldn't result in less volume being sent their way. Either way, higher risk will result in a higher discount rate and a lower multiple.

To the author: I really appreciate all the time that you put into making content for the rest of us to enjoy and learn from. However, throwing a bunch of numbers on a page pulled from Virtu's earnings presentation neither educates your readers nor contributes to meaningful conversation in the comments. Addressing the harder questions (such as those that I laid out above) would make for a much more interesting and informative article. Simply letting us know about more recent data from sources other than the company is also valuable (such as @jollyc's comment about CBOE volumes). Anyway, thanks for the article and looking forward to the next one.

[The Value Analyst]

@inv28758231
1) I mentioned the fact that there is an issue of earnings volatility although I don't believe we will see a significant impact in 2021. The long-term average of VIX is 21-23.
2) I've accounted for earnings sensitivity in my DCF, and you can assume a FWD p/e of around 9.

Thanks.

[Beer Money Arb]

@Leviathan1 spot on with your commentary, this article is only useful as a bare bones introduction to the stock.

[jollyc]

CBOE just reported record trading volumes in February. Trading volume has increased significantly with new traders entering the market (e.g. using phone-based zero commission trading platforms). VIRT benefits from higher trading volumes.

[Jozsef]

Agree. Long both Virtu and Flowtraders.
Nice hedge for the overall portfolio these long VIX plays. When there is turbulence in the market these two protect the portfolio somewhat.