Virtu Financial, Inc.

Moat: 2/5

Understandability: 4/5

Balance Sheet Health: 3/5

Virtu Financial, Inc. is a leading technology-enabled market maker and liquidity provider, operating on a global scale and offering execution services across a wide range of asset classes.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

Virtu Financial is a company operating at the intersection of financial technology and trading. They are a high-speed, technology-driven market maker, engaging in proprietary trading across various financial markets by providing liquidity and narrowing the bid-ask spread in many different instruments and asset classes. They don’t hold inventory in the traditional sense; they are in effect, providing market making services that allow other parties to participate in capital markets with ease.

The primary way Virtu generates revenue is from the bid-ask spread (or more commonly named, “price capture”) as well as payments for order flow (PFOF) through a diversified client base (mostly other trading firms). By maintaining highly accurate, fast, and technologically advanced trading systems, Virtu captures minute spreads on high volume, which generate revenue for them. This is largely a technology-driven and data-driven business which requires a lot of infrastructure investment.

Virtu’s business can be segmented into three key areas:

  1. Market Making: Providing liquidity to various exchanges and alternative trading venues.
  2. Execution Services: Enabling clients to transact in the markets via a variety of access points
  3. Analytics: Using its wealth of data to offer insights and services to clients

Competitive Landscape

Virtu operates in a highly competitive and technologically demanding market. The barriers to entry into market making are high, requiring massive capital investments in infrastructure and cutting edge software development. Furthermore, market participants are also usually highly fragmented, and they usually use many venues in which to transact, giving rise to competition. The biggest players in this market are Jump Trading, Citadel Securities, and Jane Street. These are mostly private companies that don’t regularly disclose financials publicly. The competition is usually stiff and based on speed of execution and access to financial markets with advanced algorithmic trading capabilities.

Moat Analysis (2 / 5)

  • Intangible Assets: While Virtu’s technology and algorithms are proprietary, there is limited to no defensibility since other participants use similar systems as well. The software and tech is not considered intellectual property, as this kind of software cannot be patented.
  • Switching Costs: While many market participants may find their systems and infrastructure sticky, its not an economic moat. There is very little customer loyalty, as the business can be easily taken elsewhere to another more suitable competitor. They are all competing on price, so the switching cost is minimal.
  • Network Effects: Since the market is highly competitive, this is not a business in which the network effect has any bearing. The liquidity is not limited to few players and its very easily divisible and interchangeable, so there is very little to none effect because of this.
  • Cost Advantage: Virtu certainly benefits from economies of scale, with their massive infrastructure, and therefore, they are a generally low-cost operation, this does not preclude other competitors from having the same advantages as well. Therefore, its not very beneficial of a moat compared to another company that has some unique input / output processes.
  • Conclusion: There are some minor moats, but nothing substantial. The company has some brand recognition in the high-frequency trading sector, but there aren’t any specific moats that could put the company on a sustained advantage over a lengthy period of time. The company’s competitive advantage isn’t nearly as defensible as it may seem from the outside. Therefore, our moat rating is 2/5.

Risks to the Moat and Business Resilience

  1. Increased Regulation: The regulatory environment in the high-frequency trading space is very fluid and changes quickly. The recent change of market structures and liquidity dynamics could harm Virtu’s profitability. In the Q1 2023 earnings call, the CEO mentioned that the company is actively engaged with regulators all the time, as their business model has many nuances and are subjected to different interpretations from regulatory authorities. In the latest 10Q filing, VIRT has mentioned that the company, its operations, and other business practices, in the United States and in other major financial markets, are subject to extensive governmental regulation and oversight, which will increase operational compliance costs.
  2. Technological Obsolescence: The world of technology can change very quickly. Their reliance on high speed software could be obsolete if faster trading and data analysis methods are developed, and the time needed for such a change is probably low. The company has to be at the cutting edge of tech or it will be outcompeted by its other players in the market.
  3. Market Volatility: Virtu’s revenue fluctuates greatly depending on the activity in the markets. When market activity diminishes, the trading opportunities as well as volume, both decline. The global market turmoil of 2022 caused a sharp decline in trading opportunities, volatility, liquidity, and spread capture.
  4. Increased Competition: New entrants and competitors seeking to replicate Virtu’s models could squeeze profitability and diminish the value. Smaller firms with faster execution speed can quickly make a dent in their core competency.
  5. Cybersecurity Threats: The reliance on high-speed tech also leads to an increasing risk for cybersecurity attacks. Any major attacks may cause material harm to the operations of the company. In the latest 10Q filing, VIRT has indicated that they are regularly subjected to a variety of cybersecurity threats and that material harm to the business is not entirely out of the question.

Financials

  • Revenue Streams: VIRT’s revenues are primarily transaction-based and thus fluctuate directly with market volumes and volatility. The recent turbulence of the market has been great for the company to create profits through a higher bid-ask spread. It’s worth noting that the company saw a record quarter for market making in Q1 2022, which resulted from increased trading volume and volatility. However, that has since normalized. A very small portion of revenues comes from the company’s execution services.
  • Margins: Operating margins have historically been quite high for Virtu due to its high volume business. They benefit from economies of scale. The most recent earnings calls shows a 32% operating margin which is very good, however the operating expenses are high and they need to be managed well to sustain current operations. Also, during bear markets such as the past few quarters, there have been lower volumes leading to lower net income for the business.
  • Earnings: The company’s earnings can be erratic and vary as it directly correlates with market fluctuations and opportunities. This makes it very difficult to have a very streamlined outlook of the business and can have very negative impacts on long-term valuations. For the nine months ending September 30, 2022, the company earned 1.81$ per share, and 0.36$ for the year ending December 31 2021. However, net income has recovered since then, which shows some resilience for the company as a whole. But this is mostly due to high trading volume than operational improvements.
  • Cash Flow: The company consistently has a positive free cash flow that can be used to reinvest in the business. They have used such excess capital to paydown debt, which decreases the interest burden they take on. The overall business has high liquidity and a good operating flow of capital for the business.
  • Capital Expenditure: The business has to spend considerable sums to keep its systems working and at the bleeding edge. Most of these expenses are capitalized and therefore are amortized over the long run, but if they get obsolete, those expenses will never be recovered.
  • Debt: The company currently has a relatively high level of debt. However, the business has a positive cash flow, so this is not much of a concern, and they have been proactively paying off debt during the 2022-2023 period to keep the debt under control. In the latest earnings calls, the company has committed to reducing long-term debt through excess cashflow and they also intend to lower the weighted average cost of debt (WACD). The financial statements have all been well disclosed and can be understood relatively easily and are generally consistent with the industry.

Understandability Rating (4 / 5)

Virtu Financial is overall a relatively simple concept of a market maker. Their business is relatively straightforward, since they only act as a middle man in trades. However, some aspects of their business and structure may make them slightly more difficult to understand. The different types of trading strategies they employ and how they interact with different exchanges and markets makes it hard to analyze the granular level, but overall they are relatively understandable. Hence, the rating of 4/5.

Balance Sheet Health (3 / 5)

While the company does have a decent book value of assets and a history of paying back debt, there is substantial debt on the balance sheet that makes it difficult to evaluate. However, the company has high cash flows and is well within its capabilities to paydown debt, and given the nature of the business, high debt is often employed by competitors as well. They also tend to have a lower debt-to-equity ratio than similar companies that have had to use more leverage to gain profits. Thus, a balance sheet health of 3/5.

In conclusion, Virtu Financial has shown the ability to generate consistent returns and operate within a highly fragmented industry. However, there are multiple risks that can derail the long-term outlook of the company. Therefore, it should be traded with caution and not viewed as a long-term “buy and forget” stock.