Summary
- High volatility in bond markets did not yet translate into substantial higher earnings.
- Equity remains the earnings driver for Flow Traders.
- The company did provide clarity on an ambitious growth plan and has started execution in 2022.
- As shareholders were spoiled after blowout earnings and distributions in 2020, the stock went on a decline when returns were reduced last year.
- Nevertheless Flow Traders still presents a compelling investment opportunity.
2022 has been rather tumultuous and volatile. Usually Flow Traders ( FLTDF ) is a beneficiary of volatile markets, but as the company started investing in growth, thereby reducing shareholder returns, investors decided to take money of the table sending the stock down. With growth financed from available means, share buybacks and a handsome dividend in place, I remain a buyer.
Recap
In June 2022 I wrote a bullish article on Flow Traders. At the time, the company showed its focus on growth was paying off as Exchange Value Traded had doubled and the outlook for volatility was positive as well. Compared to 2022, the VIX was trading at a higher level, but especially the MOVE, which measures volatility in bond markets, was trading at an elevated level. A level which would be supported as central banks were in the process of raising interest rates.
While equity market volatility remained elevated yet relatively steady, especially the volatility in bond markets was impressive. In September FT coined the term ' volatility vortex ' to describe the state in the bond market. One month later, figure 1 started circulating indicating the severity of losses in the bond market. As if this wasn't enough, volatility in cryptocurrency got a boost when the collapse of FTX materialized.
Summarizing, at first glance there have been sufficient reasons for Flow stock to take off and appreciate significantly, yet the reverse is true and the stock continued its descent. In this article I'll explain why I remain bullish.
Equity is king
The Exchange Value Traded [EVT] showed a decline in 2H22 compared to the first half of the year. In the third quarter press release the company sugar-coated the performance mentioning the EVT was flat whereas the numbers in the same document clearly showed a 9% decline, to wit:
Flow Traders Value Traded was flat quarter-on-quarter whereas the overall ETP market was down as increases in fixed income and currency, Crypto and commodity trading were offset by lower equity trading, highlighting the success of the trading diversification strategy.
What's more, the statement clearly indicates the continuing significance of equity compared to other asset classes. This is especially interesting when a breakdown of the value traded per asset class is considered, see figure 2.
If the items under 'Flow Traders Value Traded' are considered, it follows Equity accounts for about half of the Value Traded with the other half covered by the asset classes fixed income, currency, crypto and commodities.
Equity drives earnings
If the evolution of Value Traded is assessed, or volume if you will, figure 3 shows this has increased tremendously since the last quarter of 2021. Yet, in spite of the MOVE hovering at elevated levels, and the collapse of crypto trading platform FTX, the value traded has declined in 2H22. High volatility in bond and crypto markets in 2H22 did not significantly increase the value traded and therefore it becomes evident equity is still the driver for value traded.
Part of the traded value is captured as revenue, referred to as Normalized Trading Income by the company, as explained in previously:
Increasing our NTI involves increasing the product of volume and the net margin we capture per trade, where volume is the value of products we trade and the net margin is the margin we capture per trade after the corresponding exposure has been hedged.
If normalized trading income is referenced against the VIX, it can be seen the historical pattern, with earnings tied to volatility of equity, remains intact, see figure 4. In other words, the expansion into bonds and crypto is not yet translating into (substantially) increased earnings. As bond volatility clearly rose, the only conclusion to be made is that net margins are very slim and remained slim throughout the year for this asset class.
This is a disappointing conclusion given the current volatility in bond and crypto markets, even more so as a repetition of the volatility seen in 2022 is unlikely. Central banks have already made some extraordinary moves and are now normalizing their efforts to contain inflation. Secondly, a collapse as witnessed with FTX may not happen every year. All in all, equity continues to drive earnings, but thereby also provides a secure base.
The long view
Missing out on the elevated bond volatility, regarding earnings that is, does not automatically mean one should let go of this stock. There is an argument to let it grow instead. Previously covering Flow it was noted :
The company needs to study the markets and learn how to respond. In a new market this takes time, especially as 'responding' does not just involve a trader hitting a button.
At the 2022 capital markets day management presented a summary of what this means, also see figure 5. As the required trading capabilities are different than those present, one could argue the company basically has to start all over, only in a different asset class. This is a rather black and white representation of reality, but the point in case is that it will take time before the expansion into different asset classes will make a meaningful contribution to the trading income.
Furthermore, the company announced the intention to post an organic annual growth of approximately 20% to arrive at an NTI of €1Bn. This means the company is upping the ante as the net trading income CAGR was 17.3% in the period 2012-2021, see figure 6. Given it was just discussed the company still relies on equity to generate income, the question arises if 20% growth is within range.
As of 3Q22 the NTI was already €343.8 million. Over the entire year 2021 it totaled €384 million (2020: €933.4 million). As figure 4 shows NTI averages about €100 million per quarter, for the full year I estimate total NTI will be around €440 million. If his estimate is used, the CAGR for the 2012-2022 timespan will be 17.1%, in line with the historical performance of 17.3%.
Assuming performance will remain in line with the historic realized growth, rather than the projected 20%, the company will need approximately 4 years to achieve the targeted €1Bn NTI in 2027. If anything, the company is focusing on growth for the medium term, which further supports the thesis this company is not just an insurance for volatile markets, but can actually deliver steady income in the form of dividend and buybacks.
Shareholder returns
My previous assessment of Flow was done prior to the second quarter trading update. At the time the update contained quite some disappointing news amongst which a lower than expected dividend and 25% growth in fixed operating expenses. Yet, I still expect the company will match the €1.35 dividend from 2021. The interim dividend was €0.70 implying the final 2022 dividend should be €0.65. If the development of net trading income is taken as a proxy, this should be possible and would generate an estimated TTM dividend yield of 5.7%.
Actually, when third quarter results were presented management made known the decision to increase the share buybacks from €25 to €40 million on the back of strong performance. To put this in perspective, the company has a market cap of about €1Bn, meaning the share buybacks reducing the outstanding shares by 4%.
The stock has been declining over the past year, but actually the company has a clear agenda for growth, finances growth from available means, performs share buybacks and distributes a handsome dividend. I remain a buyer at the current level of US$23.80.
Risks
The beauty of Flow, which makes a living from volatility, is that the results are rather volatile as well, just consider the fluctuations in NTI shown in figure 6. Using the compound annual growth rate is a clever way to look past the volatility and gauge performance over a longer period. It however also comes with a flaw.
For example, when the CAGR from the 2012 to 2019 time frame is considered, one will get a vastly different number than for the period from 2012 to 2020. What's more, the data in figures 4 and 6 also shows volatility on average was at a higher level post 2020 than it was prior. In other words, if volatility reverts to pre-pandemic levels, it may very well be the growth rate needs to be adjusted downwards. For example, if the CAGR drops to 15%, the envisioned €1Bn NTI will only be achieved by the end of the decade, again taking 2012 as starting point. This means the target is 7 years away rather than the aforementioned 4 years. A small change in growth rate has a substantial effect on earnings and thus returns.
In spite of an ambitious growth target, Flow Traders is very selective in the hiring process. Actually, less than 1% of trading position applicants receive an offer. This strictness translates itself into a limited amount of new hires. For example, the company grew the amount of employees from 613 to 639 FTE between January and September 2022. This is a small expansion of FTE considering the targets. The potential risk is the company will lower the quality criteria for new-hires in favor of growth. For the short term this won't have a large effect, but over the long run this can have substantial implications for the performance of the company.
Conclusion
Equity remains the earnings driver in spite of the company venturing into different asset classes. This provides a secure base the company uses for further expansion.
Even though I believe the growth target is too ambitious, Flow Traders still presents a compelling investment opportunity as it combines growth with continued attention for shareholder returns. On the 9th of February the company will present 4Q22 and FY22 results. As Flow stock has a history to perform badly when it presents results, I consider this a buying opportunity for those who maintain a long term view.
For further details see:
Flow Traders: Growth With A Secure Base