2023-04-28 13:03:22 ET
Summary
- The Virtu Financial, Inc. share price has been in a slump for a year, but business fundamentals seem to have begun to improve in the last quarter.
- Virtu Financial thrives on market volatility, so the anticipated recession could drive its share price higher.
- Long-term investors can benefit from the Virtu Financial stock's 4.87% dividend yield while waiting for the next round of market volatility, which may drive the share price significantly higher.
In an earlier piece , I introduced Virtu Financial, Inc. (VIRT) as an ideal hedge against market volatility due to its tendency to flourish in turbulent circumstances. At that time, I made it clear by stating:
"Despite quarter-to-quarter volatility in financial performance, this analysis suggests, Virtu is a moated, consistently profitable business with extraordinary resilience in market turmoil. Investors may consider using Virtu as a hedge against general market volatility while being paid 4.31%-yielding dividends."
Since the aforementioned article was published in November 2022, market volatility, as represented by CBOE volatility index, has been on a decline, as illustrated in Figure 1. Interestingly, the share price of Virtu has lost some ground during this time. Today, the stock has a dividend yield of 4.87% .
Nevertheless, the Federal Reserve has recently projected a " mild recession " later this year, owing to the unexpected banking crisis. If this prediction materializes, the CBOE volatility index, also known as the "fear gauge," is anticipated to skyrocket, potentially driving Virtu's stock price up. Consequently, I believe it is a good time to examine Virtu's business fundamentals, evaluate its risk-reward profile, and determine if it is an opportune time to invest.
Financial performance
The decline in revenue and profits since April 2022 may have contributed to the recent slump in Virtu's share price. However, the results of the first quarter of 2023 present a positive trend reversal, as evidenced by figures 2 and 3. Sequentially, revenue increased 22.6% to reach $610 million in the 1Q2023, while net income and adjusted EBITDA rose 177.7% and 65.4%, respectively.
In addition, the margins have bounced back from their recent lows in the fourth quarter of 2022, as evidenced by the data presented in Figure 4. As of the first quarter of 2023, both the net margin and adjusted EBITDA margin have improved significantly, reaching 29.5% and 55.6%, respectively.
During the first quarter of 2023, Virtu Financial, Inc. saw an improvement in its ROIC, which rose to 25.8%, marking a 4.5% increase from the previous quarter. When compared to the WACC of 6.4%, Virtu managed to earn an excess return of 19.4% above the cost of its invested capital, as shown in Figure 4.
Despite the bearish view expressed by the market, as evidenced by the decline in the company's share price, the economic moat surrounding Virtu's business has not narrowed. This means that the company's competitive advantages remain intact.
Dividends
Virtu Financial, Inc. currently maintains a $0.96 annual dividend, yielding 4.87%. After dividend payments, it would rather to spend its excess cash flow on executing on organic growth initiatives and share buybacks than making non-organic acquisitions. Since it initiated the share repurchase program, Virtu has repurchased 14% of the fully diluted shares net after new issuances.
Valuation and risks
According to Michael J. Mauboussin and Dan Callahan , the retained cash flow after dividend payments can support a maximum growth rate of ROIC X (1- Payout Ratio). Virtu, with a cumulative dividend payout ratio of 38.7% and an average ROIC of 24.2% for the trailing four quarters, can be estimated to have a maximum growth rate of 14.9% based on the after-dividend cash flow.
To estimate the intrinsic value of Virtu, assuming an EPS growth rate of 14.9% for the next five years and 7.45% for the following five years, and using 3X earnings in year 10 to calculate the terminal value, which is reasonable considering the historical P/E of the stock , the company is reckoned to be worth around $41 per share, given a WACC of 6.4% and an initial normalized adjusted EPS of $0.61 per quarter. This estimate suggests that Virtu has an upside potential of over 100% compared to its current share price of $19.90 as of April 28, 2023. However, it's essential to note that this upside potential comes with a slew of risks as discussed below.
The main risk associated with Virtu is related to the proposed rule 605 reform by the U.S. Securities and Exchange Commission ((SEC)). Currently, stock market data is reported in two parts: trade data and quote data; the former is related to the actual transaction price and volume, while the latter pertains to the current bids and offers for a specific stock. The proposed reform suggests combining trade and quote data into a single report, which would provide investors with a better understanding of the market, particularly the demand for a particular stock at different price levels. However, this proposal has faced significant resistance from asset managers, pensions, exchanges, brokers, and issuer groups, including Virtu.
Furthermore, there is a need for more evidence to determine the sustainability of Virtu Financial, Inc.'s competitive advantage. Although the company does not take any directional risk, it may still suffer from trading losses. Lastly, it's unclear when market volatility might increase, which could impact Virtu's performance.
Investor takeaways
Although there has been a negative outlook recently, it appears that Virtu Financial's business fundamentals are starting to improve. In the first quarter of 2023, its revenue has gone up, margins have gotten better, and profits have expanded compared to the previous quarter. After all, the sustained high ROIC indicates that its economic moat is still strong.
In my opinion, the current undervaluation of Virtu Financial, Inc. presents an opportunity for long-term investors to consider investing, especially with the potential market volatility that could arise in the event of a recession (see Figure 5). To add to that, investors can enjoy 4.87% dividends as they wait for a potential surge in the Virtu Financial, Inc. share price during the next bout of volatility.
Editor's Note : This article was submitted as part of Seeking Alpha's Best Investment Idea For A Potential Recession competition, which runs through April 28. This competition is open to all users and contributors; click here to find out more and submit your article today!
For further details see:
Virtu Financial: Long-Term Investors Should Consider Amidst Looming Recession Fears