The New KCG: Is It Worth Your Investment

Knight Capital Group has now merged with Getco and the combined entity, KCG Holdings has relisted on NYSE with the same ticker symbol, KCG, as of July 2, 2013. Knight Capital Group, a formerly public company, and GETCO Holding Company LLC, a formerly private company, now operate as subsidiaries of KCG Holdings Inc, which is a public company with not much change in the operating businesses.

If you recall, Knight Capital stock melted down in August last year when a computer glitch in its program trading algorithm flooded the market with millions of unintentional orders in a 45 minute period, causing Knight Capital to take a loss of $461.1 million. Subsequently, Knight secured rescue financing of $400 million from a group of investors including Jefferies and Getco, in exchange giving up 70% stake in the company. In Dec 2012, Getco ended up buying the entire company for $1.4 B, Jefferies arranging the funding for the deal. The merger is now finally closed and the new merged company operates under the KCG Holdings name.

Terms of the Deal for the Former Knight Shareholders

Original Knight shareholders received one of the following (based on their election):

  • $3.75/share in cash in exchange for the original Knight shares, or,
  • 1 share of new KCG stock for every 3 shares of original Knight Capital shares

If we keep this simple, the acquirer valued the original KCG shares at $3.75/share. The new KCG shares are therefore valued at $11.25/share (1 new share for 3 original shares). The new KCG stock is currently trading at $11.28/share so it is pretty much at the acquisition value.

The question is, if we believe that KCG shares were trading at a distressed levels before the merger was completed, are the shares even a better value today? Pre-merger, Knight Capital was a distressed business with its capital structure in a mess and limited access to the capital markets. Post-merger, with the addition of the much sounder GETCO business, the capital structure is on a much firmer footing and the access to the capital markets is much more open.

Quick Look at the Consolidated and Combined Financials

Only a few days have passed since the merger has completed and there are no financial statements reported for the new company. Since GETCO was a private company, its past financials are not available to the public. However, Knight Capital Groups’ Notice of Special Meeting of the Stockholders (Jun 25, 2013) lays out unaudited proforma combined financial data that I reproduce below:

Proforma Income Statement Case 1: 100% Elect to receive shares Case 2: 100% Elect to receive cash
In $Millions Q1 2013 2012 Q1 2013 2012
Revenues $ 398.10 $ 1,141.80 $ 398.10 $ 1,141.80
Expenses $ 388.70 $ 1,565.00 $ 388.70 $ 1,565.00
EBIT $ 9.40 $ (423.20) $ 9.40 $ (423.20)
Tax $ 3.60 $ (150.30) $ 3.60 $ (150.30)
Earnings $ 5.80 $ (272.90) $ 5.80 $ (272.90)
Basic EPS $ 0.03 $ (1.50) $ 0.05 $ (2.31)
Diluted EPS $ 0.03 $ (1.50) $ 0.05 $ (2.31)

Please note that you can download the entire document in pdf format here. It contains historical financial data for Knight Capital Group as well as GETCO that can help you better understand the operations of the 2 companies, which you need to read it you are considering a possible investment in KCG.

The total number of shares outstanding for KCG is 358,198,000 giving it a market valuation of $4.04 Billion today.

Case 1 represents the scenario where 100% of the old Knight Capital shareholders elect to receive new shares for their old shares. Case 2 is the maximum case where 100% of the shareholders elect to receive $3.75/share in cash, up to an aggregate maximum cash payout of $720 million. The preliminary stockholder meeting vote counts indicate that over 97% of the Knight Capital shareholders elected the cash option (Case 1). Since 97% is very close to 100%, we will from now on only consider the Case 2 proforma.

The proforma income statement is produced as if the two companies merged on Jan 1, 2012. Please note that in August 2012, Knight Capital had an extraordinary loss of $461.1 million, which is included in the 2012 column. Ideally to get a sense of the stable ongoing business, you would remove the effect of this one time extraordinary event, assuming that the chances of this recurring are minimal. To do this, we will have to

  1. add back $461.1 million to the EBIT. This gives an adjusted EBIT of $37.8 m
  2. reverse the tax effects for the losses booked. In 2012, the company booked a tax benefit of 35.6%. In Q1 the company booked a tax payable of 38.3% on EBIT. Lets take an average of these 2 numbers or 36.95%. The tax on the adjusted EBIT would have been $13.97 m
  3. Adjusted Earnings (2012) = 37.8 – 13.97 = $23.83 m
  4. Adjusted 2012 EPS = 2.31*23.83/272.9 = $0.20/share. This is in line with Q1 2013 EPS.

In terms of a Price to Earnings multiple, it appears that the investors are currently paying 11.28/0.20 = 56.4 times earnings for the combined company.

Not reasonable at all. However, we looked at a 1 year data which is a very small data set. GETCO has also seen its revenue and income decline in the recent years due to lower trading volumes. The Knight Capital part of the business is still in the process of rebuilding the trust in its high speed trading and market making platforms, and the business is improving. GETCO paid for the potential, and if Knight Capital business gets back to its historical levels, the picture will be very different. To get a more reasonable view, we will have to consider historical financials going back many years, so this is not yet enough to write off this stock as overvalued.

Proforma Balance Sheet

Proforma Balance Sheet Case 1: 100% Elect to receive shares Case 2: 100% Elect to receive new cash
In $Millions As of Mar 31, 2013 As of Mar 31, 2013
Cash and equivalents $ 1,125.70 $ 405.70
Financial Instruments owned (fair value) $ 7,551.30 $ 7,551.30
Investments $ 145.90 $ 145.90
Income Taxes receivable $ 123.00 $ 123.00
Total Assets $ 12,747.90 $ 12,027.90
Short term debt $ 235.00 $ 235.00
Long term debt $ 624.20 $ 624.20
Total Liabilities $ 10,575.20 $ 10,575.20
Total Equity $ 2,172.70 $ 1,452.70

Using Case 2, the stock is currently trading at $4,040/1452.7 = 2.78 times the book value. Most of the similar investment brokerage/trading companies are currently trading at Price to Book ratio close to 1.

Bottomline

At this time the valuations do not suggest great opportunity. The opportunity lies in the future recovery of the business that was decimated subsequent to the trading glitch, so it is quite possible that the investors will make money over time as this comes to pass. The opportunity was of course greater when Knight Capital was independent and the financials were no diluted with the addition of GETCO operations. It is still worth keeping an eye on the stock over time to see if the improvement materialize and how quickly.

Comments

  1. VP Rajesh says

    Hi Vishal – You may want to adjust the book value with one-time loss of over $400 million to get a true picture of the BV multiple. It will not change the outcome but the methodology will be apples-to-apples with the P/E multiple calculation you have shown above.

    Have they announced what’s the final outcome of the elections made by the shareholders?

    Rgds,
    VP Rajesh
    Ross’97

    • says

      I have not seen the final vote count. It is supposed to come any day now.

      You should not adjust the book value since it is a snapshot in time unlike the income statement. When we look at the income statement, we are concerned with figuring out the true steady state operation, hence all these adjustments netting out the one off gains and charges. With the balance sheet, it is what they have and that is what they have to work with, it is already a true picture. If it improves over time due to profitability, it will show up on the balance sheet and book value in the form of retained earnings.

      Regards,
      Shailesh

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