$VIRT -- Why I'm still a buyer

What did we really learn from today's earning pre-announcement?

As of 3:56 pm today shares of VIRT are down 14.76% on a preliminary announcement of the first 2 months of Q3 earnings.

Before breaking down what the news is and what it means, I’ll first explain what Virtu Financial (VIRT) does. VIRT is a market maker that provides liquidity in global equity markets. In essence what they do is act as a middle man between buyers and sellers. They profit on the spread of the bid/ask (quoted prices for buyers and sellers). As market volatility increases, the spreads increase and market makers make more money.

Now to break down the news that sent this stock tanking. VIRT announced preliminary results for the third quarter to date through August 2020. The numbers were not what the market wanted. Net trading income was adjusted to between 295 and 303 million. Daily trading income at the midpoint was about 7.30 million per trading day.

This was significantly lower than the previous quarter which saw trading income of 744 million. That would break down to about 11.625 million in income per trading day. So sequentially the trading income was down about 38%. On the surface it’s understandable why the market reacted. However looking below the surface, I still see evidence to suggest that VIRT is a buy.

What drove he sell off?

First lets look at VIRT’s year over year financials. The slide below shows their 2019 Q3 performance.

In the previous year for the entire Q3 they realized 249.8M in Adjusted Net Trading Income. In the preannouncement for 2020 Q3 they gave an estimated ANTI of between $238-246M. That means in the first two months of 2020 Q3 they did the income that they did in all 3 months in the year prior! An absurd number which paces them to have grown revenue’s in the range of 50% YOY. Clearly then VIRT’s top line numbers are fantastic.

The valuation on VIRT is also not a factor. After today’s sell off it trades at around a PE ratio of 7 (Price to Earnings). In any market that’s a cheap stock. However in today’s market that’s absurdly cheap. So the logical conclusion is that the market is assuming that this release indicates a return to normality in the volatility of markets? Maybe they believe that Post-Covid, trading volumes are going to return to normal levels and so will VIRTs growth? Let’s examine in the chart below.

Using the Nasdaq 2020/2019 Monthly Volume statistics, August was the least active month of the year so far. This would explain why the drop sequentially in trading income, however year over year August volumes were still up 12% in equity trading. In options trading, the volume was up 37% year over year in August. Also when looking at trading so far in September, volatility looks to be up around 34% year over year for the month to date. When you consider the upcoming November election, the potential 2nd wave of a virus and the lingering economic effects from the Coronavirus Pandemic, it’s hard to believe that volatility will normalize soon.

However even when all of this ends and is in the past, it’s likely that stock markets will continue to be active until at least 2023. I believe drivers of this include interest rates remaining at 0, no transaction fees, apps like Robinhood, Acorns, WeBull, CashApp and the rise of fractional shares.

All of the above indicates that market volatility has not slowed and likely will not slow to the pre-Covid level. Even assuming that transaction volume does decrease, it’s likely that the August level reflects the new normal. An increase of around 12% seems very reasonable. This would put VIRT around a FCF of 333M when compared to it’s 5 year average. The EV/FCF would be around 17. When you consider that this company already had a 3 year revenue growth average of near 30% and a 5 year average of 16%, it’s hard to find any company on the market with that type of growth at that multiple.

In all likelihood VIRT will have a very good Q3 and an outstanding Q4 and have a record year of revenues. At some point the market will take notice and this stock will rally. I would not be surprised if by year end VIRT rallies into the mid/upper 30s. We bought on the dip and will continue to buy tomorrow if it continues to go lower.