Fructivore Investments

Investment Technology Group (ITG) is in an interesting situation; the company primarily operates a trading platform and provides brokerage services, as well as providing investment research. As you may know, trading volumes have been low for the last few years, never having reclaimed the peak levels of 2008. This has naturally affected ITG’s earnings and share price, both of which have declined precipitously. However, ITG has a substantial amount of cash on hand, and that, combined with their current earnings power, makes them an intriguing candidate. Also, the view among analysts is that ITG is going to turn the corner and return to a modest growth situation, but even if this proves not to be the case (and I am generally suspicious of analysts on the whole), ITG should do well if it merely holds the line on its current earnings.

Investment Technology Group’s primary business is as a broker-dealer and operator of a trading platform, as well as providing original research and trade optimization and processing services to clients. More than 85% of the company’s revenue comes from non-recurring sources like commissions, but the company has been attempting to broaden its offerings to the more repeat-customer oriented field of research. To this end, it has acquired two research firms in the last couple of years. The company has a presence in the United States, Canada, Europe, Australia, and Hong Kong. Its electronic trading networks cover equities, futures, and options, and allow clients to trade with anonymity and without revealing their own orders, and also to scan multiple networks for uncommitted orders. These traits are highly valued in trading large blocks of shares or illiquid stocks.

As a result of continuing low volumes, Investment Technology Group has engaged in significant restructuring over the last few years. Consolidation and curtailment of their operations has enabled them to draw down significant amounts of working capital in 2010. As it is stated in Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance, a useful book on important details of cash flow accounting, one expects working capital to expand alongside a growing business and recede with declining ones. The restructuring has consolidated some locations and removed the company’s physical operations in Japan entirely, among other things, and also freed up cash to devote to acquisitions and share repurchases.

Over the last few years the company has been deploying its cash flow first to pay down its long-term debt and, recently in 2010 to repurchase stock. It is reasonable for a company that relies on volumes in the financial markets to deleverage itself as much as possible, although the firm has added about $30 million in long term debt in 2011, in addition to the acquisitions mentioned above. It is, strategically speaking, a defensible decision to diversify the company’s revenue sources, and furthermore subscription research is probably more recurrent than trading commissions as a source of revenue. However, I do have issues with the prices paid; the latest acquisition was for $38.5 million for a firm which is reported to have $15 million in sales and a pre-tax margin of 25%. Assuming taxes of 40%, this is an after-tax return of $2.25 million per year, or a yield of 5.894%, which is lower than ITG’s earnings yield even before taking excess cash into account. As a result, I would have preferred that extra money to go to buybacks.

Turning now to the figures, the extent of ITG’s excess cash is an important question. The company has $381 million in total cash on its balance sheet, of which $25.5 million is on deposit with clearinghouses and $71.5 million is restricted in some other ways. This leaves $281 million of unencumbered cash. The company’s other current assets are exceeded by its current liabilities in the amount of $121 million, so there is, under our customary test, $160 million in excess cash. However, as a broker-dealer the company is subject to regulatory capital requirements which, across its total operations, come to $210 million. The company’s actual regulatory capital is $365 million, and this $155 million excess has remained fairly constant over the years. Obviously, it would be unwise for ITG to dispose of its entire excess, but the company tries to close its positions one way or another by the end of trading, so its only real exposure is to its clients’ credit quality. As a result, I think the bulk of this excess regulatory capital can be considered excess cash, particularly as the two calculation methods tally so closely at present. Furthermore, the company has generally met its operating capital needs with cash flow from operations, and has paid for its acquisitions in cash, thus bolstering the hypothesis of a large amount of excess cash. Furthermore, the company has a line of credit to address other short-term capital needs. The company’s current market cap of $470 million can thus be reduced to $315 million to produce the denominator of the free cash flow yield calculation.

In terms of earnings, as of this writing the company has released its full year results but not its 10-K that would contain an audited cash flow statement, but based on cursory examination capital expenditures has equaled depreciation and amortization. Sales were $572 million, reported operating income was -$204 million but impairments, restructuring charges, and acquisition costs were $257 million, producing operating cash flow of $53 million. Interest expense that year was $2 million, producing pretax free cash flow of $51 million, or $31 million after estimated taxes of 40%. This is a free cash flow yield of 10%, which is an adequate return on investment especially in today’s environment, if not an exciting one.

In 2010, sales were $571 million, operating income was $50 million, impairments, restructuring, and acquisition charges were $12 million, and excess depreciation was $9 million, producing operating cash flow of $71 million. Interest expense was $1 million, resulting in pretax cash flow of $70 million, or $42 million after estimated taxes. The company was also able to draw down working capital significantly during this year.

In 2009, sales were $633 million, operating income was $79 million, restructuring charges were $25 million, and excess depreciation was $3 million, producing operating cash flows of $107 million. Interest expense was $3 million, leaving $104 million in pretax cash flow to equity, or $62 million after estimated taxes.

In 2008, before the extent of the downturn was fully known, sales were $763 million, operating income was $202 million, and capital expenditures exceeded depreciation by $13 million, producing operating cash flow of $189 million. Interest expense that year was $7 million, producing pretax cash flow to equity of $182 million, or $109 million after estimated taxes.

On a forward-looking basis, as I said before, it seems to be the general view among analysts that the downtrend in the company’s earnings has run its course and that prospective earnings will be marginally higher. Although I generally dislike indulging analysts, I will note that sales, if not margins, were flat in 2011 as compared to 2010.

I am concerned that share-based compensation has increased from $10.4 million in 2008 to $18 million in 2010, and $13.8 million for the first three quarters of 2011, even as incomes have declined. Furthermore, as I said above the company has overpaid for acquisitions relative to the constructive yield on share repurchases. However, the company does have 4.9 million shares, or over $50 million’s worth at current prices, in repurchase authority left, so if the company stocks to that plan I think ITG shareholders will benefit.

As a result, I can say that although Investment Technology Group may not be a traditional value stock, it offers a reasonable earnings yield and should be considered a candidate for portfolio inclusion, particularly for investors who feel optimistic about a recovery in market volumes.

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Investing by grocca