Why Knight Is a Great Value, If You Can Stomach It
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By now you’ve certainly heard the news: Knight Capital Group’s (NYSE: KCG) computerized trading system spun into a frenzy, issuing erratic orders without actual buyers or sellers.
The chaos ensued for roughly 30 long minutes. For a company like Knight – which earns fractions of a cent in fractions of a second – 30 minutes is an eternity. Knight lost $440 million in that fateful half-hour, and company stock plummeted 62 percent, closing at $2.58 a share at the end of trading on Thursday. Wall Street filled with whispers that Knight would be mercilessly acquired at ultra-bargain prices, unless it could find an investor to save it. (Cue the “White Knight” jokes.)
Within 24 hours, though, value investors gave Knight a chance, shooting the stock up 56 percent by market close on Friday.
Are the optimists triggering a temporary blip on the stock price of a doomed company? Or is Knight the greatest value buy of the year?
My stance is that Knight is a great value buy, if you can stomach some short-term uncertainty. Here's why.
#1: Company Valued at $800 Million
The analyst firm Keefe, Bruyette & Woods estimates that Knight’s value, after its losses, now stands at $800 million.
Knight has 98.21 million shares outstanding. At the close of market on Friday, it traded at $4.05 a share, valuing the company at only $397 million. This indicates that Knight is dramatically undervalued.
In other words, the company lost a third of its value, but the stock plunged by two-thirds, given its risk and uncertainty. A proper share price (adjusted after last week's losses) would be $8.14 (or less to account for short-term volatility and the company’s own liquidity risk).
It’s appropriate for Knight to be undervalued as long as the company’s future remains in question. But assuming that Knight doesn’t fall victim to a half-price takeover, its current share price points to a golden opportunity.
#2: Knight Had Cash
As of June 30, Knight had $365 million in cash and a $70 million line of credit, for a total of $435 million in cash/cash equivalents, according to ValueWalk. The company's loss was $440 million, which is remarkably close to the amount of cash it had on hand.
Knight had to tap its emergency coffers to deal with the crisis, but it had the necessary means to do so. It can now go back to business as usual, with a focus on rebuilding its cash reserves.
#3: Knight Has Friends
While Knight’s competitors and other would-be entrants to the wholesale market making field would love to see a takeover, Knight has friends who can lend it any cash it needs to tide itself through the emergency. Knight reportedly is leaning on JPMorgan Chase (NYSE: JPM) for emergency funding.
As of March 31, JPMorgan had $55.4 billion in cash and cash equivalents on hand, so Knight’s supporter is at no risk of running out of funds. The question isn’t can JPM and other lenders support Knight, but will they?
Knight’s competitors – which include Citidel LLC, Citigroup, Goldman Sachs and UBS – may pressure JPM not to lend its support. But my feeling is that JPM’s lawyers, fearful of any perception of collusion in this high-profile drama, will make sure JPM continues to lend money to Knight.
#4: Brokerages Returning to Knight
The only other wild card is the question of whether or not brokerages like Vanguard and Fidelity – the clients who use wholesale market makers – will regain enough trust in Knight to resume business with the company.
When the computer debacle took place on Wednesday, major brokerage houses had to re-direct their orders to Knight’s competitors. Citidel LLC confirmed that it saw a huge surge in trading volume on Wednesday, while UBS, Citigroup and Goldman Sachs declined to comment.
Signs point toward brokerage houses resuming their status as a Knight client. TD Ameritrade (NYSE: AMTD) and ScottTrade both resumed business with Knight on Friday, according to the Wall Street Journal. Knight’s long history as a market maker gives the company both credibility and extensive relationships. TD Ameritrade described the company as one that has "long been a good and trusted partner," MarketWatch reported.
The Bottom Line
I believe Knight will avoid a buyout, recover from the glitch, and resume business as usual. Those investors who buy Knight at a low price will be rewarded.
PaulaPant has no positions in the stocks mentioned above. The Motley Fool owns shares of JPMorgan Chase & Co. Motley Fool newsletter services recommend TD AMERITRADE Holding. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.
