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Potential buyers take stock of Knight

by Suzanne Miller | Published August 6, 2012 at 9:05 AM

As Knight Capital Group Inc. frantically scrambles to save itself from potential oblivion, many are wondering whether it's worth more whole or broken up.

For the moment, the company is reported to have secured a line of credit to help shore up operations, though a Knight spokeswoman was unavailable to comment Friday, Aug. 3. But the firm's future still hangs precariously in the balance as many ponder Knight's best options for survival.

That survival is even a question for Knight -- the largest trader in U.S. equities -- would have been unthinkable prior to Wednesday, when the company first disclosed a software glitch involving 150 stocks. The glitch triggered a momentous $440 million trading loss in just 45 minutes, which caused a massive share selloff that wiped out more than $300 million of the company's market capitalization. On Friday afternoon, the company's market cap stood at about $365 million.

Stunned analysts have been offering up conflicting perspectives that reflect just how hard it is to fathom the abrupt crisis enveloping one of Wall Street's most venerable market makers. "On an ongoing basis we believe they're seriously undervalued," said Michael Wong, an analyst with Morningstar Inc. in Chicago. But in the same breath he admitted that right now, "we wouldn't be buyers at any price."

The trading loss is slightly more than the $365 million in cash the company had on its books at the end of the second quarter and is money the company will have to replace. Barclays plc analysts estimate that the loss has caused the company's tangible book value to sink from $11.48 per share prior to the loss to $6.73. That has prompted Barclays to drop its price target to $3 a share from a previous $12.

Some suggest that a private equity firm might be the most likely buyer for Knight, rather than a major bank or one of Knight's three key competitors, which are UBS, Citigroup Inc. and Citadel LLC. Analysts said banks are less likely to enter the market-making business right now, while Knight's competitors may be worried about too much overlap. Equity trading has become more competitive at a time when volumes have been falling and market share for the big incumbents has been stagnating. Knight Capital has a market share of roughly 17% on the NYSE Euronext and roughly the same on Nasdaq OMX.

But some of Knight's businesses could be attractive, particularly to a private equity buyer. "A number of their businesses are worth a lot," said Larry Tabb, founder and CEO of Tabb Group LLC, a research and strategic advisory firm. "Possibly you might get a private equity firm involved to clear it up and bridge it for a month or year and sell it off. [But] right now it may look more interesting to break it up."

Knight Capital, for instance, has a retail electronic fixed-income business that Wong said is "the industry trend, the place where the margins are the highest, returns on capital are highest and where future growth is best." Wong estimates that Knight could fetch a "good multiple" on pretax earnings for this business. It also has an attractive institutional trading business and a relatively new European market-making business, as well as a nascent but growing business in listed options, which is also highly desirable right now.

Wong also pointed to Knight's acquisition of the futures division of Penson Worldwide Inc. in the second quarter as a plus. He said the purchase "gives the company a foothold in futures to complement its existing capabilities in equities, options and fixed income." Knight has also been planning to expand its clearing operations to other asset classes "and offer a correspondent clearing business," Wong added. Knight self-clears through its Knight Clearing Services division.

Moreover, Knight owns a 19% stake in privately owned Direct Edge Holdings LLC, which is rumored to be in talks to be purchased by Toronto's TMX Group Inc. for between $300 million and $500 million. Direct Edge is the fourth-largest U.S. stock exchange, handling roughly 10% of daily U.S. equity trading volume.

Knight also has an attractive underlying balance sheet. In a note, Wong said "we believe the company's balance sheet is relatively clean. At the end of 2011, the company had none of the opaque level three assets that got many of the investment banks into trouble." He also said that most of the company's assets are "fairly vanilla" listed equities, options and fixed income, and that it has no material, if any, over-the-counter derivatives.

However, the question of potential liabilities looms large. Many worry, for instance, about legal liabilities if investors decide to sue. "The other big issue, is there going to be legal liability for those that bought those stocks (when they were going up)? If I bought a stock that was moving up because of an error, is the person that caused that error responsible for my loss?" Tabb said. At this point, these and other potential liabilities remain difficult to quantify.

Perhaps one of the single biggest liabilities facing Knight is the loss of customer confidence. As Barclays analysts said in a market note, "Ultimately, and in short order, customers need to have confidence to transact with Knight Capital, because without that revenue generation is impaired, and the impact on earnings consequently can make it difficult for the company to retain employees."

Already, a number of high-profile clients have reportedly fled, at least for now. If Knight can't win them back very soon, that could erode future business in a way that will make it extremely difficult to recover in the long run.

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