VIRT - Virtu Financial Benefits From Rising Trading Volume & Asset Diversity

2023-07-06 17:15:48 ET

Summary

• New York-based market maker Virtu Financial has reported Q1 revenues of $556.66mn, a 9.72% YoY decline, and a net income of $55.20mn, down 49.07% YoY.
• The company's success is attributed to its ability to attract liquidity and order flow across all asset classes, and its client-oriented approach.
• Despite a financial decline due to reduced trading activity, Virtu is expanding its asset base and is rated a 'buy' due to its product diversity and strong capital deployment strategy.

Virtu Financial ( VIRT ) is a New York City, New York-based market maker with an array of services and offerings across trade execution, liquidity sourcing, analytics, and broker-neutral, multi-dealer platforms. The company engages in all major asset classes, including equities, commodities, currencies, options, fixed income, etc. on public exchanges and dark pools.

Through these activities, Virtu has recorded $556.66mn in Q1 revenues- a 9.72% YoY decline- a net income of $55.20mn- down 49.07% in the same period- and a free cash flow of -$27.89mn, largely a product of reduced operating cash flows.

Introduction

At the core of Virtu Financial's success remains its ability to attract adequate liquidity and order flow across all asset classes and execute upon buy and sell information to collect on the bid-ask spread. To do so, the firm remains committed to maintaining a client-oriented approach, servicing the buy side-including asset managers and pension funds- and the sell side-including investment banks and other institutions- alike for utmost satisfaction. This capability is enhanced by the Virtu's expertise across global market structures, its state-of-the-art high-frequency platform, specialized liquidity solutions, and its multi-asset approach.

The combined effect of the firm's product diversity and scale orientation, alongside a strong capital deployment strategy and moderate undervaluation, lead me to rate Virtu a 'buy'.

Valuation & Financials

General Overview

In the TTM period, Virtu-down 28.44%- has trailed both TradingView's Brokerage Index-up 17.70%- and the general market, as represented by the S&P 500 ( SPY )- up 16.01%.

I believe this reflects broader reductions in liquidity and retail investor anxieties, which have translated into reduced order flow, thus spread-based fees, for Virtu.

On the other hand, other brokerages are generally larger and less purely based on transaction volume, like Virtu is versus asset values.

However, I believe that, while Virtu has experienced a material financial decline due to reduced trading activity, the market has overreacted to temporary headwinds, especially with Virtu expanding its asset base.

Comparable Companies

Virtu's primary competitors in high-frequency market making activities are firms such as Jane Street, Hudson River, and Citadel Securities, all of whom are not publicly listed. And while firms like Goldman Sachs and Morgan Stanley are public, their operations are too large and diversified to adequately compare to Virtu. As such, I sought to compare Virtu with similarly sized non-retail financial services companies; this group includes global-advisory focused investment bank PJT Partners ( PJT ), investment banker and asset manager Lazard ( LAZ ), trading platform servicer and operator StoneX ( SNEX ), and M&A focused Piper Sandler ( PIPR ).

As demonstrated above, despite strong growth capabilities in addition to well-placed multiples-based value, Virtu has experienced the second-poorest quarterly performance in addition to the poorest yearly performance, largely off the back of temporary headwinds.

For instance, Virtu Financial maintains the lowest trailing and forward P/E ratio among peers, alongside the second-lowest P/S and P/B ratios after StoneX, another company I recommended as a 'strong buy'.

This runs in conjunction with the second-best ROE and demonstrably strong long-run revenue growth and earnings growth-the respective best and second-best in the comparison group. Despite this, manifesting Virtu's short-term theme, the company has experienced the poorest 5-year stock price performance.

And with a strong 5.65% dividend, investors can expect a capital allocation strategy developed with shareholders in mind.

All this comes at the price of an above-average debt/equity- but by no means unmanageable- of 1.09, with yearly cash flows barely affected by debt responsibilities.

Valuation

According to my discounted cash flow valuation, at its base case, the true value of Virtu should be $20.52, with the stock, at its current price of $16.76, undervalued by 18%.

My model, calculated over 5 years without perpetual growth built-in, assumes a discount rate of 9%, reflecting the firm's slightly above average debt levels in addition to a slightly higher ERP due to higher price volatility as of recent. Additionally, to smooth out highly volatile revenue growth, shifting at least double digits for every year of the past 5, I assumed a revenue growth rate of 7%, lower than the market-making industry CAGR of 10.6%.

Alpha Spread's multiples-based relative valuation tool aligns with my thesis on undervaluation, estimating that Virtu is undervalued by 56%, with its fair value being $38.14.

However, Alpha Spread's model fails to account for leverage or cash flow generation uncertainty in its models. Therefore, the tool seems to overvalue the stock.

Thus, taking a weighted average of my DCF and Alpha Spread's relative valuation-skewed towards my DCF- the stock's true value should be $23.10, with Virtu Financial being undervalued by 27%.

Strong Capital Management Alongside Organic Business Growth Drive Value

As I've discussed previously, the versatile range of assets Virtu operates within is a core strength of the firm, enabling diverse and relatively resilient cash flow generation alongside supporting broad-based scale growth. Through this, despite generally volatile revenue streams, Virtu has achieved a 39% 5Y CAGR when concerned with daily net trading income. More recently, Virtu has extended this strategy to the rapidly growing options market making, ETF block trading activities, and opportunities in crypto-based market making.

This strategy serves to enhance Virtu's disciplined capital allocation strategy, with a majority of free cash flow going towards effective reinvestment strategies-recording a 4Y ROIC of 37%- alongside a judicious capital return with a stable, high-yield dividend of 5.65% and opportunistic share buybacks and deleveraging programs.

Wall Street Consensus

Analysts reiterate my positive opinion on the stock, estimating an average 1Y price target of $21.38, meaning the stock is projected to grow 27.01%.

Even at the minimum projected price, when incorporating dividends, investors can expect to net double-digit returns, with the lowest Wall Street price target set at $18.00, 6.95% higher than its current price.

I believe this mirrors analyst opinions on the market's overreaction and Virtu's operational strength, which I foresee will support a price reversion.

Risks & Challenges

Compressed Retail & Institutional Trading Activity

Inflationary pressures, in addition to rising and sticky interest rates, have led to depressed investment capabilities for retail investors and institutions alike. Since Virtu's success is highly dependent upon active trading volume and ascertaining order flow, the company may experience slower scale growth and reduced profitability, with the same number of market makers competing for less trading volume.

Talent Dependency & Competitive Intensity May Compress Margins Regulatory Structures May Inhibit Growth

The operational behaviour of high-frequency market makers is very similar to one another. As such, Virtu may fail to differentiate itself from major market-making competitors means that the firm's success is dependent upon Virtu's ability to keep up with competitors, whether it be on a cost basis or on an innovation basis. The latter objective runs parallel to the retention of talent, which can lead to expanded operational costs and lower cash flows for reinvestment or shareholder returns.

Conclusion

Going forward, Virtu's multi-asset platform as well as its highly scaled strategy and capital deployment efficacy will catalyze a reversion to Virtu's fair value.

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