2023-03-30 16:02:57 ET
Summary
- Flow Traders Ltd. should be a solid portfolio hedge, benefiting from market volatility.
- At the same time, underlying fundamentals are improving, and regardless of the portfolio hedge potential, the stock looks undervalued.
- There are some risks and uncertainties, but the overall risk-reward is positive; thus, Flow Traders is a buy.
Note: Flow Traders Ltd.'s U.S. ticker ( FLTDF ) appears to be no longer tradable. The primary listing ( FLOW.AS ) is tradable on Euronext.
Thesis
Flow Traders Ltd. is one of the few companies with a low correlation to overall market movements, but instead, the stock moves based on volatility expectations, making it potentially an excellent portfolio hedge. Furthermore, the underlying fundamentals are improving. Even without considering its hedging potential, Flow will likely deliver strong shareholder returns from the current price.
Overview
Flow Traders is a liquidity provider mainly focused on exchange-traded products, or ETPs, but they have been expanding into fixed income, currencies, commodities, and crypto.
Trading in 180 venues and exchanges with more than 2,000 counterparties.
The company was founded in 2004 with €1 million in equity capital. Since then, they've made more than €3.5 billion in net trading income.
Flow Traders' strength and core focus is on the exchange-traded products . The majority of the exchange-traded products consist of equity ETFs. For example, suppose an exchange-traded fund ("ETF") composed of 50 stocks valued at €100 per ETF share is trading at €100.01. In that case, the trading algorithm will create new ETF products for the market and sell those for €100.01 while simultaneously buying the right amount of each 50 different underlying stocks at €100 for each ETF product sold, making a tiny €0.01 profit for every ETF, until the ETF price matches the value of the underlying asset. Or if the ETF is trading at a discount to NAV, the same happens the other way around. It all happens automatically and instantly in milliseconds.
This type of liquidity providing may sound risky, but Flow Traders never had a year of losing money and rarely any losing trading days. So everything is well hedged, and they always focus on the risk first.
On average, for every €1,000 traded, Flow makes less than 7 cents of net trading income, which leads to just over 2 cents of net income.
Flow Traders is a market leader in ETP products in Europe, with a 33% market share . Market dynamics are very different in the Americas compared to Europe and Asia. The total ETP value traded in the Americas was €44.7 trillion; in Europe, it was only €2.4 trillion; and in Asia, it was €1.6 trillion in 2022. Flow Traders traded a total of €892 billion in the Americas and €787 billion in Europe, but the profitability in Europe is much stronger, and in Europe, they made a net trading income of €316 million, compared to €90 million in Americas. Asia's profitability is also in line with Europe's.
So, unless there is something fundamentally different in these markets, the profitability should also decrease as the markets grow. So, if the European ETP market doubles, I would expect Flow Traders' NTI (net trading income) to go up but not to double.
If I assume that everyone made the same amount of NTI in these markets (I'm sure it is a way too simple way to look at it, but maybe it gives some indication of what happens when the markets develop.) In the Americas, €44.7 trillion traded with Flow Traders margins would lead to €4,500 million NTI compared to Europe of €2.4 trillion traded, leading to €960 million NTI. So the Americas market is 18.6x larger, but profits are only 4.7x higher. Again, this is too simplistic way to look at it, and maybe there are fundamental differences in these markets, making the Americas less profitable, but the general point is that the profits are unlikely to grow linearly with the market growth.
Over the past decade, Flow Traders has grown NTI at 20% CAGR. Every time there is a spike in market volatility, it will lead to record profits for Flow Traders, making it an outstanding countercyclical stock to own. At the same time, the overall ETP market has grown rapidly and Flow Traders in line with it, improving its profitability also during low volatility years. The market is expected to keep growing as funds move from active to passive investing and new exchange-traded products get developed.
While the overall market has grown and Flow Traders' trading capital has increased, they still managed to make 60% NTI returns on the trading capital in lower volatility years. 60% NTI returns will lead to around 20% net income returns for the trading capital. If they can generate similar returns going forward, this company will compound investors' money like mad.
In 2021, only 25% of the trading capital was deployed in equities, while equities made 65% of the total NTI. Currently, fixed income and CCC, which includes commodities, forex, and crypto, are much more capital intensive and less profitable, but as they scale those businesses, they expect the returns to improve.
Flow Traders recently opened a trading office in Shanghai. It didn't cost more than a few million euros investment, but if successful, I believe they could eventually make an additional €10-€50 million annual net income from China as the ETP market develops. If they fail, well, they just lose a couple of million. That's what I call a great risk-reward investment.
Financials
In low volatility years, they used to make around €50 million net income, and in a crazy volatility year like 2020, they made almost €500 million net income. Since the overall ETP market has grown, Flow Traders got more trading capital and better trading capabilities; I expect them to make closer to €60-€80 million net income in low volatility years. I think the average annual net income should be somewhere around €150 million, maybe even €200 million if there is more volatility.
In the past eight years, they made a total of €1,150 million in net income (earning almost the current market cap in the past eight years), of which 61% or €700 million was paid in dividends. For the next eight years, the net income and dividends should likely be higher than in the past.
On the balance sheet, they do not have any interest debt, and the shareholders' equity is €600 million. Of that €600 million equity, more than €500 million is net cash, and the rest consists mainly of property, plant & equipment.
Going forward, the dividend payout ratio was slightly lowered to 50% of the net income as they currently find great opportunities to deploy additional capital in trading.
Employee compensation
Flow Traders got a unique employee compensation program where employees share profits the company makes, and most employees are also Flow Traders shareholders. Flow Traders' policy is to pay out 32.5% of operating results in variable employee compensation. A large part of the compensation consists of share-based payments, where a large chunk of the stock does have a certain vesting period. In case there will be losses in the following year, the losses will be deducted from employees' deferred compensation plan, which incentives risk avoidance.
While this type of compensation program is quite expensive, it aligns employees to think like shareholders, motivates them to work harder, find new solutions, and focus on risk avoidance. In addition, the compensation helps Flow Traders to attract the best talent in the world to join the company. Less than 1% of the Flow Traders job applicants will get accepted. Also, management share from the variable compensation pool is only 6%, so most of it goes toward employees and is not just used to enrich the management.
Risks
This business is very difficult to understand, and I can't claim that I totally get what they do. The management can't explain the business in great detail because that would give information to the competition and hurt their operations. I don't know if there will be regulatory or technological changes that make their business model either less profitable or obsolete in the future.
While Flow Traders is highly focused on risks, in their 19-year history, they never lost large sums of money. If there was some error in their automated trading system or counterparty default, Flow could lose a large chunk or the entire trading capital. I'm not smart enough to understand the likelihood of this risk materializing. Is there a 5% or 0.05% annual chance for it? I don't know.
Given Flow Traders Ltd.'s recent restructuring , the FLTDF ticker is defunct and all trades must be made via the Euronext FLOW.AS ticker. Average daily volume is fairly low at 136k shares, and low liquidity may pose hazards to the unwary investor.
Valuation
Most analysts hate this business because it is impossible to estimate future earnings. In my opinion, analysts actually don't even value businesses. Instead, they are trying to predict the next 1 to 2 years' earnings and then throw some terminal multiple on top of it. I can't blame them because most of their clients just want to know what stocks go up in the short term. That's why Flow Traders is never properly valued based on fundamentals but rather trading based on if they exceed or fall short of analyst expectations. It makes the stock volatile, and except for fat dividends, the price hasn't moved anywhere and is down from the IPO (back then, they had a massive earnings growth year, and analysts modeled the growth to last forever).
Management's target is to maintain 20% organic growth. The goal is to achieve €1 billion net trading income in a normalized volatility year. If they can do that, it will lead to about €400 million in net income. If there is still some growth left and positive sentiment, the market could offer a P/E multiple of 20. That would lead to an €8 billion valuation or up 7x from the current market cap. It could happen in 5 years.
I hope this happens, but I'm a bit more conservative on my valuation model.
I made three different valuation scenarios with a 10% discount rate below: (ignore the dates, it's an outdated valuation model sheet).
On the base scenario, I assume average earnings of €150 million. 50% dividend payout ratio and the rest of the profits are used as trading capital generating 20% returns, leading to a 10% growth rate. However, because I can't be sure about their business model's long-term sustainability, I only calculated 10 years of earnings. After that, I assumed they would close operations and distribute all the accumulated cash to shareholders, discounted accordingly.
The bullish scenario is the same, except the average net income is €200 million, and I'm calculating earnings over the next 20 years.
And the Bearish scenario is ten years earnings model with only €100 million average earnings and just a 10% return on additional trading capital, leading to a 5% growth rate.
Then I added a 5% likelihood of something horrible happening and this investment going to zero.
For a 50% chance of base scenario, 25% for a bullish, 20% for a bearish, and 5% for the worst scenario, the net present value for a 10% return is €1.45 billion, which is about 20% above the current market cap. Even if the bearish scenario materializes, it should be fairly valued for a 6% annual return, and currently, 40% of the market cap being in net cash offers some downside protection.
So, from a conservative perspective, the average expected return for Flow is around 12%. If the management target materializes, it will return a whole lot more.
On top of that, Flow Traders' stock price mostly moves in line with volatility instead of the general market, which means you could rebalance the stock by adding more during low volatility times and then selling during high volatility. In the past, selling above €30s and buying for around €20s was a great strategy. For example, if you sold during the 2020 market crash, you would have made a 50% return first by selling Flow and then could have deployed those profits to invest in other stocks trading at discounted valuations.
Virtu Financial
I also analyzed Virtu Financial, Inc. ( VIRT ). However, they focus more on trading pure equities and bonds, while Flow Traders focus more on ETP products. I somewhat understand the need and necessity of dealing with ETP liquidity, but I don't understand Virtu's business model.
Additionally, Flow Traders has no interest debt and has around €600 million book value with more than €500 million net cash, compared to the market cap of €1.25 billion. On the other hand, Virtu has only around $200 million book value compared to the market cap of $3.1 billion, and they also have a total of $1.8 billion interest debt.
Conclusion
In my opinion, Flow Traders Ltd. is undervalued based on its fundamentals. Additionally, the stock could work as a portfolio hedge against market volatility, and actively rebalancing or trading it could boost the returns. However, there are risks; unless you work in the company, it's impossible to understand their business comprehensively. Additionally, future earnings are impossible to model, which is why analysts hate it, and Flow Traders Ltd.'s stock is very volatile. However, overall, Flow Traders Ltd.'s stock is a buy for me.
For further details see:
Is Flow Traders A Perfect Hedge?