Summary
- Despite a 3-decade presence on Wall Street, few investors are likely to have heard of ITG.
- ITG has a clean balance sheet, with over 16% of its market capitalization in net cash.
- Increasingly diverse revenue base, from both a geographic and business perspective is helping drive double-digit growth in operating profits and EPS.
- Management has a solid track record of returning capital to shareholders; since 2009, over 20% of shares have been repurchased.
Few people are likely to have ever heard of Investment Technology Group (NYSE:ITG), hereafter referred to as ITG. For over 30 years (the company was founded in 1983), ITG has operated behind the scenes of Wall Street, offering its institutional financial industry clients a variety of necessary, but decidedly mundane products and services, such as order execution and portfolio analytics software. With a market capitalization of under $700 million, ITG does not have much in the way of sell-side coverage, and despite its 3-decade presence on Wall Street, the company is under-followed. And it is that lack of coverage and attention that has created what we see as a compelling opportunity in shares of ITG.
Our thesis for ITG is based in large part on the company's three key drivers of EPS growth, which are, to some extent, interconnected. In addition, our thesis is further supported by ITG's compelling valuation. We will begin our discussion of ITG with an overview of the company's business, followed by a review of the company's Q3 results. Then, we will turn our discussion to ITG's drivers of EPS growth, and the company's compelling financial position and valuation. Among the sources used in this write-up will be ITG's 2013 10-K, itsQ3 2014 earnings release, its Q3 2014 earnings presentation, and its Q3 2014 earnings call.
Overview
With well over $500 million in annual revenues, ITG operates in multiple global markets (a key growth story, more on that later) across a variety of different business lines. In 2013, the U.S. accounted for just under 60% of sales, and the company's Electronic Brokerage business is ITG's single largest business line, also accounting for a little under 53% of sales. We break down ITG's 2013 sales by product line and geography in the graphs below.
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ITG's single largest business is its Electronic Brokerage unit, and we turn now to a brief overview of each of ITG's businesses.
- Electronic Brokerage: Accounting for a little under 53% of sales, the Electronic Brokerage unit houses ITG's core trading businesses. Through its proprietary POSIT platform, launched in 1987, ITG offers traders access to its Alternative Trading System (or ATS), as well as that of other dark pools. Key to ITG's success in this market is that the company does not compete with its clients for liquidity. The POSIT system is designed to prioritize client order execution above all else, and unlike many broker-dealers, ITG has no issues with telling clients where and how their orders were executed. Customers using ITG's products receive access to detailed execution reports (a sample report can be found here) that allows them to see precisely where and how their trades were executed. In addition to the POSIT system, ITG's Electronic Brokerage unit also offers derivatives trading of listed futures and options, commission management services for its clients, and securities lending for short-sales.
- Research, Sales, and Trading: Accounting for just over 20% of sales in 2013, ITG's Research, Sales, and Trading unit houses the company's investment and markets research, as well as its high-touch sales and trading desk. ITG's equity research team is different from the typical sell-side model, given that ITG has no investment banking business, meaning that the research produced is free of any perceived sell-side bias (whether or not that is in fact an issue is beyond the scope of this write-up). And ITG's market research team conducts research into a variety of industries and sectors (such as oil and healthcare) for the company's corporate clients, similar to the research produced by companies such as Gartner or IDC.
- Platforms: ITG's Platforms unit houses the company's order execution and management offerings. The unit's core offering is Triton, a multi-asset and broker neutral execution management system, which offers ITG's customers a suite of execution and analytical tools. The company also offers a variety of management offerings, including compliance monitoring, outsourcing, and ITG Net, which is a network of over 500 global brokerages and execution venues designed to connect buy-side and sell-side firms together for order matching and routing.
- Analytics: ITG's Analytics unit houses the company's trading and portfolio analytics offerings, which are designed to give traders and portfolio managers insight and data into their trading and capital. The unit offers product such as transaction cost analysis software that allows investors to measure costs across the entire span of a trade, both in explicit and implicit terms, and portfolio optimization tools that allow clients to model tax implications of a given set of transactions, transaction costs, as well as the results of adjusting a portfolio's long-short strategy, if one exists.
ITG's various units operate in tandem with one another to deliver a complete suite of trading and portfolio tools for the company's institutional clients. And increasingly, the company's institutional clients are based outside the United States, a trend that is becoming apparent in the company's revenues. In the first three quarters of 2014, the U.S. accounted for 54.89% of total revenues, down over 500 basis points versus 2013 levels. International revenues are helping drive not only revenue growth at ITG, but profit growth as well, a trend that is apparent in the company's results so far this year. We turn now to a discussion of ITG's results for Q3 2014 and the year so far.
Q3 2014 Results: Margin Expansion Rules the Day
ITG's results for the 3rd quarter of 2014, released on November 3, demonstrate, in our view, the long-term potential of the company's business model. While ITG missed consensus EPS estimates by a penny, the company easily beat on revenues, and we believe that on balance, ITG's performance for the quarter was solid. We present a consolidate overview of ITG's results for Q3 2014 and the year-to-date in the table below (note: EPS figures have been adjusted by seven cents to exclude a one-time tax benefit recognized in Q3 2014)
ITG Q3 2014 Results (in Thousands of $)
When simply looking at ITG's revenue performance, investors are likely to be underwhelmed. While revenues grew by 5.66% in Q3 2014, they grew by less than 3% so far this year; on paper, this is hardly what most investors would call inspiring growth. However, while revenues grew by single digits in both Q3 and 2014 to date, operating income and EPS grew by double digits, which reflects the strength of ITG's business model, which forms a core of our bullish thesis on the company (much more on this to follow later). We turn now to a discussion of ITG's revenue performance in its two most important segments, Electronic Brokerage, and Research, Sales, and Trading.
Revenue in the Electronic Brokerage unit rose by 3.67% in Q3 2014, driven by continued international growth in volumes, which has allowed ITG to offset sluggish volumes here in the U.S. While total POSIT volumes in the U.S. fell by 2% year-over-year, Canadian and European volumes grew in the high single-digits. Overall, average daily POSIT volumes stood at 71.5 million shares in Q3 2014, up 8% year-over-year. However, a shift to sell-side volume drove down revenue per share to $0.0046, down from $0.0049 a year ago. For ITG, sell-side order flows carry structurally lower revenues than buy-side orders; with sell-side volumes accounting for 56% of total volume in Q3 2014, versus 51% last year, it is inevitable that ITG's revenue per share would decline. We believe that it is prudent to note that the split between buy-side and sell-side volume can be volatile from quarter to quarter, thereby injecting volatility into ITG's revenue per share; in Q2 2014, revenue per share was $0.005, which represented a year-over-year increase of over 4% versus Q2 2013. However, continued international expansion has allowed ITG to more than offset sluggish volumes here in the U.S. That being said, we believe that the company will see an improvement in trading volumes in the 4th quarter. As management noted on the company's Q3 earnings call, market volatility in October has pushed up the company's average daily commissions by 7% versus its Q3 average. In addition to volatility increases, we believe that Q4 2014 brokerage revenues will also benefit from a recent acquisition.
In July 2014, ITG announced the $80-million acquisition of RFQ-hub, a Paris-based provider of quote technologies for global listed and OTC equities and derivatives. The goal of the deal was to expand ITG's European presence and increase its base of recurring revenues. Per comments from management on the company's Q2 2014 earnings call (held in August), 90% of RFQ-hub's $6 million in forecast 2014 revenues are to be generated in Europe, and almost 85% of the revenue is recurring in nature. The deal is expected to become accretive to EPS in 2015, and we expect more color on RFQ-hub in late January, when ITG is likely to report its Q4 2014 earnings. The RFQ-hub acquisition highlights ITG's commitment to Europe as an area for growth; total European revenues grew by almost 40% in Q3 as ITG booked a 46% increase in the value of its average daily POSIT trading and took further share within the continent (ITG's key European offices are in London and Paris). However, while ITG did manage to continue growing overall brokerage revenues, the real "star" of the quarter was the company's research division.
In Q3 2014, ITG's Research, Sales, and Trading unit grew revenues by over 14%, driven by strength in both ITG's corporate market and equity research units. During the quarter, the company launched coverage of around 20 new companies, and delivered strong performance in its energy, telecommunications, and healthcare market research division, which now accounts for ~15% of segment revenue. It should be noted that ITG's research division has material synergies with the companies brokerage division; POSIT users that are also ITG research clients pay fees that are ~80% higher than non-research users. The continued growth of the Research, Sales, and Trading unit is gradually reducing ITG's reliance on volume to drive revenue growth; the unit now accounts for 22.6% of total sales, up from ~20.9% a year ago. ITG has committed itself to growing its research segment and making it a more meaningful part of the company's overall revenue base in 2015. We expect expansion into new corporate market verticals to occur in 2015, coinciding with a continuing expansion of its equity research coverage universe, which will serve not only to continue providing ITG with revenue and profit growth, but also with further diversification away from volume-driven revenues. As we mentioned earlier, ITG's revenue growth, while perhaps uninspiring to some on its own, is only part of the story, and we turn now to one of the pillars of our bullish thesis for ITG: the company's ability to grow EPS.
Growing EPS: Three Powerful Levers
We turn now to ITG's EPS growth, which is a key part of our bullish thesis. ITG's ability to drive solid EPS growth is possible due to three distinct, but somewhat interconnected reasons, and we discuss these below.
While ITG's revenues in Q3 grew by less than 4%, the company booked a 12% increases in operating profits for the quarter, and increased operating profits by more than 20% so far this year, off of revenue growth of less than 3%. ITG's ability to grow operating profits at a rate far higher than revenues is a testament to the saleable nature of its business. Because much of ITG's business depends on software, algorithms, and other intangible products, new clients and increases in the uses of ITG's products are highly accretive to the company's operating profitability, as there is little incremental cost associated with the increase in revenues, thereby allowing ITG to generate double-digit incremental operating margins. We break down the company's incremental growth in operating profits in the table below.
ITG Incremental Operating Margin (in Thousands of $)
Q3 2014
|
YTD 2014
| |
Y/Y Revenue Change
|
$7,215
|
$11,947
|
Y/Y Operating Income Change
|
$1,361
|
$8,273
|
Incremental Margin
|
18.86%
|
69.25%
|
With consolidated expenses rising by just 1% so far this year, ITG's year-to-date operating margins have expanded by 171 basis points to 11.92%. ITG's ability to extract meaningful operating profit growth from single-digit increases in revenues is a key part of our bullish thesis for the company, and highlights the benefits of its business model. ITG's ability to realize revenue growth even amidst soft trading volumes highlights the benefit of having a diverse revenue base of capital markets businesses that are able to grow regardless of global trading volume trends. And in periods of volume growth (such as October 2014), ITG's ability to grow revenues, and thereby operating profits, is expanded even further. The operating leverage built is a key component of the company's ability to post EPS growth of 25% in Q3 2014, and almost 35% so far this year (we remind investors that this excluded a 7-cent benefit to EPS from the resolution of certain U.S. tax contingencies). However, operating leverage is but one of the drivers of ITG's EPS growth. The 2nd lever is the continued growth of ITG's international business, and the structurally higher margins under which its international segment operates.
While the U.S. accounted for almost 60% of ITG's revenues in 2013, the percentage of ITG's revenues generated by its domestic business continues to shrink. So far this year, the U.S. has accounted for less than 55% of total revenues, and in Q3 2014, the ratio fell below 54%. But the key benefit of this increase in international revenues lies not in ITG's ability to tap into faster-growing overseas markets, but in the split of costs between ITG's domestic and international operations. ITG's global costs are structurally tied to its U.S. operations, thereby significantly reducing the profits that the company books in its domestic operations, while significantly increasing its international margins. For context - ITG's domestic segment had a Q3 2014 pre-tax margin of just 1.4%, whereas its combined international operations (Canada, Europe, and Asia-Pacific) posted a pre-tax margin of 17.7% for the quarter. ITG public company costs, interest expenses, and amortization costs are all borne by its U.S. segment, which allows the company to structurally increase the profitability of its international operations to a rate far higher than it is capable of generating here in the U.S. Furthermore, most of ITG's employees are also based in the U.S.; per the company's 2013 10-K, over 71% of the company's total employees were based in the U.S, meaning that much of the company's compensation costs are also borne by its U.S. segment.
The key benefit of such a structure is the effect that it has on ITG's tax rate, which is gradually moving lower as more and more of the company's revenues are generated outside the U.S., even as the bulk of the company's costs continue to be incurred here at home. In the table below, we present a breakdown of ITG's consolidated tax rates for Q3 2014 and the year to date, as adjusted to exclude the one-time tax benefit booked in Q3.
ITG Tax Rates (in Thousands of $)
Q3 2014
|
Q3 2013
|
Y/Y
|
YTD 2014
|
YTD 2013
|
Y/Y
| |
Pre-Tax Income
|
$12,078
|
$10,690
|
12.98%
|
$47,186
|
$38,815
|
21.57%
|
Provision for Income Taxes
|
$3,113
|
$2,975
|
4.64%
|
$11,675
|
$11,394
|
2.47%
|
Tax Rate
|
25.77%
|
27.83%
|
-7.39%
|
24.74%
|
29.35%
|
-15.71%
|
Net Income
|
$8,965
|
$7,715
|
16.20%
|
$35,511
|
$27,421
|
29.50%
|
While ITG's pre-tax income in Q3 2014 rose by just under 13%, the company saw a 16.2% increase in net income, as the company's tax rate fell by over 200 basis points to less than 26%. And for the first three quarters of the year, ITG's net income surged by almost 30%, as the company's tax rate dropped below 25%, a decrease of almost 5 full percentage points versus 2013. The continued increase in ITG's international revenues in relation to its U.S. revenues is likely to lead to further reductions in the company's overall tax rate, given the fact that the bulk of ITG's costs will continue to be borne by its U.S. operations. The combined effects of ITG's incremental operating profit growth, and the increasingly international nature of its revenue base and the associated decline in income tax expense that arises from this serve to increase ITG's cash flows, which help power the company's third lever for EPS growth: sustained share repurchases.
ITG is an active repurchaser of its own stock; since 2009, the company has reduced its share count by over 20%, as shown in the chart below. 
In October 2014, ITG's board of directors expanded the company's share repurchase program by 4 million shares, bringing the program up to a total of 5.4 million shares (as of October 15, 2014), or just under 15% of ITG's current fully diluted share count of 36.026 million outstanding shares. But, ITG's current share repurchase program does not necessarily represent the limit of the company's potential. As its net income continues to rise, cash flows will rise as well, giving ITG increased ability to expand its share buybacks even further from present levels.
Despite a clear path to EPS growth, shares of ITG continue to trade at multiples that we do not believe are reflective of the company's true value. When combined with a strong balance sheet, we believe that ITG's current stock price has created an asymmetric opportunity for patient investors.
Financials & Valuation: A Compelling Proposition on Two Fronts
Despite its aggressive share buybacks, ITG's balance sheet remains solid. The company ended Q3 2014 with $228.461 million in unrestricted corporate-level cash & investments, and $110.863 million of debt, giving the company a net cash balance of almost $118 million, or $3.26 per share, based on ITG's current fully diluted share count (equivalent to over 16% of the company's current market capitalization). We note that these cash balances are separate from ITG's regulatory capital requirements. As the company's 10-K notes, the company's regulatory capital is held in a special restricted portion of ITG's balance sheet, titled "cash restricted or segregated under regulations and other." Capital in this line item is permanently restricted to meet ITG's capital requirements under various U.S. and international regulations, the most important of which is S.E.C. Rule 15c3-3,also known as the Customer Protection Rule. This rule, first adapted in 1972, bars broker-dealers such as ITG from utilizing customer funds and securities for any business purpose other than servicing customer accounts. Under Rule 15c3-3, U.S. broker-dealers must both maintain physical possession or control over their customers' fully paid and excess margin securities (meaning they cannot be subject to any creditor liens) as well as maintain a reserve of cash or other securities that is no less than the net cash that the broker-dealer owes to its customers.
In addition to having a clean balance sheet, ITG also carries a compelling valuation. In the table below, we present current consensus forecasts for ITG's sales and EPS, as per figures from Bloomberg (consensus forecasts for EBIT are unavailable); estimates are accurate as of the close of trading on November 7, 2014 and are subject to change.
ITG Forward Estimates (in Thousands of $)
Year
|
Revenue
|
Y/Y Change
|
EPS
|
Y/Y Change
|
$504,436
|
N/A
|
$0.21
|
N/A
| |
$530,801
|
5.23%
|
$0.97
|
361.90%
| |
2014
|
$557,000
|
4.94%
|
$1.37
|
41.44%
|
2015
|
$578,000
|
3.77%
|
$1.47
|
7.29%
|
2016
|
$608,000
|
5.19%
|
$1.76
|
19.43%
|
2017
|
$605,000
|
-0.49%
|
$1.75
|
-0.46%
|
Source: Bloomberg, company filings
The decline in sales and EPS forecast for 2017 is a function of the composition of the estimates used to calculate consensus figures; given that not all projections are included in the 2017 figures, the numbers are inherently skewed. But, for the sake of conservatism, let us accept these figures at full face value. Based on these consensus forecasts, ITG is projected to grow sales at a compound annual growth rate of 3.33% between 2014 and 2017. But, EPS is projected to grow by a CAGR of 15.9%, due to the three factors we discussed above. However, ITG currently trades at a 2014 P/E multiple of just 12.05x [based on a current share price of $19.79 (as of the close of trading on November 7), adjusted for $3.26 per share in net cash]. We do not believe that ITG's current stock price accurately reflects the company's fair value, and believe the company deserves to trade at a PEG ratio of 1, which we believe would accurately reflect the company's growth potential. Assigning a P/E multiple of 15.9x to ITG's estimated 2014 EPS of $1.37 yields a pro forma price target of $25.08, representing upside of over 26% relative to the company's current share price.
In our view, there are several pathways to unlocking ITG's fair value. First, the company's buybacks will continue throughout the remainder of 2014 and 2015, providing a boost to both ITG's share price and its EPS. Second, potential increases in volatility in 2015 are likely to lead to further increases in ITG's share price, due to the positive impact that this has on the company's commission income. Third, the company's continued growth in research, sales, and trading revenues, which will help ITG diversify away from its core electronic brokerage segment, will increase investor confidence in ITG's ability to grow sales and profits independent of market volatility (even if ITG has already demonstrated an ability to do so).
Conclusions
At present levels, shares of ITG are undervalued. The stock trades at just over 12x 2014 earnings, even though the company is projected to grow EPS by an average of almost 16% annually through 2017. The lack of awareness and coverage of ITG on Wall Street has helped create what we see as an asymmetric opportunity in the company's shares. ITG has multiple levers that it can pull to drive EPS growth: a scalable business model, an increasingly international revenue base and the lower tax rate that this shift brings about, and continued aggressive share buybacks. As ITG continues to execute on its growth strategy, we believe that the company's stock price will rise to reflect ITG's long-term potential, and the clear value that we believe is present in the stock at current levels.
Source:http://seekingalpha.com/article/2662905-investment-technology-group-a-profitable-investment-in-the-global-capital-markets
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