EP56: Virtu-ous Cycle
Stock Ideas From Investment Professionals
Welcome, subscribers! 3Q investment letters have begun to hit our inbox, so we’re back to deliver the best of what we find. Today, we share pitches for an out of favor market maker and a small-cap telco, plus 4 other unique ideas.
Read on to learn more. 📕👇
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Let’s get to it.
East 72 Dynasty Trust provided a lengthy and detailed thesis on Virtu Financial (VIRT), a market maker/liquidity provider. Its most recent quarter was one of the company’s most profitable ever. Is it sustainable? We provide an excerpt of East 72’s pitch below and encourage you to read the whole thing.
Virtu Financial: from lust to loathing
In one guise or other, in January 2024, assuming Dynasty Trust is still holding, I will be into my SEVENTH year of having exposure to Virtu Financial Inc (VIRT), though not necessarily continuously. Given what Virtu does, even allowing for cycles in its earnings, that’s a long time.
Virtu Financial, with an equity market capitalisation at end September 2023 of just over US$2.8billion1 and with $1.8billion of long-term debt due in 2029, is the sole listed US based “liquidity provider”. Liquidity providers, or market makers, are a controversial industry of financial market “plumbers” who are receiving extra unwanted and tainted publicity with the release of the movie “Dumb Money”2 regarding the meme stock explosion of securities like Game Stop and AMC Entertainment in early 2021. The March quarter of that year was Virtu’s second most profitable ever, measured by “daily profit”. The short term “sugar-hit” has provided a longer-term hangover – an SEC enquiry and proposed tighter regulation.
Whilst many of its competitors, by dint of financial regulation have to make public disclosures, VIRT make more than any other in its business. And when your industry is full of mathematical, analytical, programming geniuses, additional disclosure is not what you want. So it is always with trepidation that our desire to invest in a stunningly profitable, hefty return on capital, highish barrier to entry business, is tainted by the fact the investment is in the only US publicly listed business3.
VIRT have pulled back on certain elements of disclosure since 2019 & 2020 whilst providing other elements of non-financial papers which assist in providing the ability to judge their performance over the short term; we will discuss these aspects as we delve into how Virtu make their money.
In assessing Virtu’s publicly listed history from April 2015 onwards, despite the business being developed to advantage by asset sales, strong access to debt markets and two notable acquisitions, investor valuation of Virtu’s earnings has declined sharply. The lust of market making profits in 2014-2015 has turned into a loathing due to competition, rapid development of alternative products - such as zero-day options - attracting the retail speculator, and an aggressive regulator diverted by simplistic public opinion and potentially seeking to pull down what to us looks like an extraordinarily efficient market structure.
It has meant that VIRT has had to run hard, despite being in a phenomenally competitive position amidst the democratisation (retail participation) in stock trading, which enabled it to reap outsized benefits in 2021. Innovation moves extraordinarily rapidly in markets: trends in exchange traded products are to Virtu’s advantage. However, they have lagged in the options area, especially single stock options rather than index options. Given several competitors have grown up in the options area (notably Susquehanna) the slower pace of development is mildly concerning.
We put forward the case of why we hold Virtu as a Top 10 position in Dynasty Trust by describing the business, its history and acquisitions, the regulatory threat to Virtu, the ability of the company to earn super-profits for brief periods, its aggressive capital management initiatives, cost disciplines and an assessment of appropriate valuation metrics.
So why is Virtu stock so bombed out?
From our return charts above, Virtu’s profitability seems close to a low point since the “appalling” 2019 period where equity markets in the US moved up on extremely low volatility, leaving very little scope for market making profits. The prevailing environment in 2023 seems rather different, so there is some hope for a respite and a return to more normal bid-offer spread/volatility in market making and adequate volume for execution services.
Given the cycles inherent within the business, any expectation of improvement would usually see the price multiple for the stock expand slightly to account for a low(ish) point in the cycle – not so here. Remember in the last twelve months, on our adjusted numbers, Virtu earned less than one-third of the Q1 2021 peak cash profit before interest and tax of $1.57billion.
There are three possible explanations for this:
• Regulatory environment;
• Specific legal claims lobbed at Virtu by the SEC; and
• Potential perception that Virtu is not well placed in a highly competitive if growing industry. SEC Equity Market Structure Proposals
Whilst the 2021 “meme-stock” boom was an enormous short term positive for market makers, the gradual disclosure of payments for order flow and the eventual decisions by many firms to stop new open positions in Game Stop (amongst others) precipitated a perception amongst retail traders that the market was rigged against them With new relatively new, commission free platform, Robinhood being a major beneficiary of the trading boom, it admissions over the quantum of fees received from PfOF led to enquiries and eventual settlement deals with SEC.
In the wake of the meme-stock demise, SEC investigated a number of practices from the period and in mid-2022 presaged a significant overhaul of stock trading. In December 2022, SEC put forward new Equity Market Structure proposals which are the most radical since the NMS overhaul of 2005. Whilst the “industry” – exchanges and wholesalers (like Virtu) are generally in favour of greater quote transparency and a selected reduction in “tick” sizes, more politically motivated attempts to change the system have been vehemently opposed. The most aggressive comments have been against a SEC’s proposed new retail auction system whereby wholesalers would bid for customer orders from the initiating broking, rather than have the broker award them to wholesalers as part of a PfOF or other contractual arrangement.
Looking from the outside, even with exceptional technology, the auction system appears ridiculously unwieldy, and unnecessary with other acceptable proposals enhancing market transparency which the industry believe is acceptable.
Virtu (and others) response is that the “retail auction” proposal would actually widen spreads and make markets more opaque. Further, most of the wholesalers and exchanges want any changes to “best execution” protocols delayed to accommodate the impact of changes on tick sizes and enhanced order execution information.
In our view, the original extreme fear over SEC proposals has dissipated, and should start to decline further over time, with a unanimous view from all major market players.
Specific legal claims against Virtu
As the most publicly clear company detrimentally impacted by SEC-proposed legislative change, Virtu (mainly via CEO Douglas Cifu) commenced a campaign to see the proposals watered down. The campaign – commencing in June 2022 – became increasingly vitriolic and personal as a result of Virtu’s views not just about potential legislative change but the manner in which SEC was promulgating the proposals – in Virtu’s view, with inadequate public discussion. Virtu sued SEC to gain further details and around its Q3 2022 results was particularly scathing over SEC’s behaviour, specifically that of SEC Chair Gensler who it accused of being political rather than regulatory.
There is little doubt that SEC has concerns over PfOF and the dominance of a small number of firms in the off-exchange business (read Citadel and Virtu), SEC have now brought forth various charges against Virtu – made public in September 2023 regarding potential breaches of Virtu “internal information barriers” between January 2018 and April 2019. Virtu’s attempts to settle with SEC have been unsuccessful and the case will proceed to court. In a statement on 12 September 2023, Virtu explicitly linked the case with their prior criticism and legal action regarding the Equity Market Structure proposals.
In our view, investors have been put off Virtu by its aggressive stance, even though on cold evaluation, the chances of a materially financially damaging impost against the company appear remote.
Competitive environment
Aside from the cyclically depressed trading conditions over twelve months, with slowing volumes - year to date (end August statistics) show traded value down 17% over 2022 (although the offexchange values in the same period have fallen by only 8.6%), there is an increasing perception that in some areas Virtu is not innovating quickly enough against strong competition.
At each quarterly earnings briefing, Virtu disclose daily adjusted net trading income from “new initiatives” which are currently defined as options market making, ETF19 block trading and crypto. Clearly the results will fluctuate with overall market environments, but the type of strong growth expected from a low/zero base hasn’t really materialised, and the initiatives have (currently) petered out at around 10% of overall NTI/day:
On a rolling twelve-month basis, the latest addition of $135million is well down on FY22, which is baffling given the visible growth in the options market, where Virtu appear to be focused on index rather than single stock options. Given the credentialed competitors in the options market, there is a genuine fear that Virtu will potentially have to seek out an expensive acquisition at a time they are under-earning. We have confidence that Virtu are proceeding diligently but would prefer to see more visible initiatives.
Conclusion
Virtu is at an interesting competitive juncture. The “lit” exchange owners – ICE (NYSE), Nasdaq and Cboe – all of whom are publicly listed, are chasing growth in the NON exchange market either in mortgages (ICE), data provision (Cboe) or areas like workflow and indices (NASDAQ). All trade on forward P/E multiples of 17 – 21x FY2024 earnings to reflect the value of data or their new initiatives; if Virtu trades at 8x P/E, one might reasonably argue whether their other activities are VERY heftily valued given their equity exchange earnings are also not growing.
Investors seem to be reasoning that Virtu has limited scope to grow or has “lost its mojo” and worry about its bickering with the regulator. Whilst cognisant of these arguments, we see the long-term results of others in the sector and believe once the regulatory fog clears, investors – and given the Viola family control, perhaps even a corporate – will see the clear value in the stock.
In the meantime, the 5.6% dividend yield and voracious share buy back regime should provide a floor under the shares awaiting more conducive spread conditions.
Palm Valley Capital Management had an active third quarter. The firm purchased positions in 4 new companies, including Avista Corporation (AVA), Farmland Partners (FPI), Equity Commonwealth (EQC), and SSR Mining (SSRM). We include Palm Valley’s brief pitch for each one below.
We purchased four new names: Avista Corporation (ticker: AVA), Farmland Partners (ticker: FPI), Equity Commonwealth (ticker: EQC), and SSR Mining (ticker: SSRM). We believe these opportunities materialized because higher interest rates are disproportionately impacting investor sentiment toward certain sectors, even as capitalizationweighted, tech-heavy indexes have powered through the headwinds.
Founded in 1889, Avista is a regulated utility with operations in Washington, Idaho, Oregon, Alaska, and Montana. Avista provides electricity to 411,000 customers and natural gas to 377,000 customers. As interest rates have increased, utility stocks have significantly underperformed the broader stock market. Avista’s stock has also been under pressure as wildfires have become a more obvious risk for investors. We believe Avista is currently generating below normalized earnings. Approximately half of Avista’s electricity is produced from low-cost hydroelectric generation. Weather conditions over the last year reduced the company’s hydroelectric output and increased its cost of production. Additionally, we also expect earnings to lag in 2023 because the company’s last approved rate increase in Washington was insufficient to cover the subsequent unexpected rise in inflation. Avista filed a new Washington rate case in June 2023 that takes higher costs into consideration and, if approved, should go into effect in 2025.
Avista is selling at 14x 2023 expected earnings and 13x our normalized estimate. Furthermore, at 1.05x tangible book value, the firm is at a considerable discount to its historical net asset valuation. We expect Avista’s earnings to reach our normalized estimate by 2025 and believe the company’s long-term growth objective is achievable given its territory’s large capital investment needs. While utilities are not risk-free, at Avista’s current valuation, we believe we are being adequately compensated for risk.
We bought a small position in Farmland Partners (FPI) during the quarter. FPI is a real estate investment trust (REIT) focused on farmland. As of June 30, 2023, FPI owned 159,000 acres of farmland with a book value of $1.1 billion. FPI’s stock has declined year-to-date as higher interest rates have increased its borrowing cost and pressured earnings. Management believes the value of its farmland, net of debt, exceeds its market capitalization, and they have been repurchasing stock. The company intends to sell $190 million of farmland in 2023 and will use the proceeds to buy back more stock and reduce debt. While rising interest rates are a risk to FPI’s near-term earnings, the stock is trading at a discount to reported book value and our higher net asset valuation.
Equity Commonwealth (EQC) is another real estate investment trust we purchased in Q3. The company focuses on commercial real estate and owns properties in Denver, Washington D.C., and Austin. Over the past nine years, EQC has been busy selling its portfolio of commercial real estate, generating $6.9 billion in proceeds. It used these funds to reduce debt, buy back stock, pay dividends, and build a large cash balance. At the end of June, Equity Commonwealth had $2.15 billion in cash that it intends to use to buy real estate at attractive valuations. Similar to our investment strategy, Equity Commonwealth is patient, opportunistic, and is willing to hold a large cash balance when opportunities are scarce. EQC is trading below book value and at a level equal to the company’s cash balance.
SSR Mining is back in the Fund after a brief hiatus. SSR is a precious metals producer with four mines located in the United States, Turkey, Canada, and Argentina. The company is selling at a meaningful discount to its tangible book value and our calculated net asset value. SSR has a very strong balance sheet with more cash than debt and $4.6 billion in stockholders’ equity. Furthermore, the firm has a history of generating free cash flow, buying back stock, and paying a sustainable dividend.
Recurve Capital detailed their thesis on Cogent Communications (CCOI). They believe their $1 acquisition of Sprint’s wireline business will lead to a step-change in Cogent’s free cash flow generation in the coming years. Recall that we shared Alphyn Capital’s pitch for CCOI back in July. Both are worthy reads.
Cogent Communications - The Wavelength Opportunity
This post is about optical transport services, a specific and technical part of wireline telecom that is not well known to most investors, but is critical network infrastructure for cloud infrastructure providers (AMZN, GOOG, MSFT), AI companies (OpenAI, Anthropic, etc.), content companies, and other cable/telco providers (CMCSA, CHTR, etc.).
It is an important end market to Cogent (NASDAQ: CCOI), one of Recurve's portfolio companies, but also to Lumen (NYSE: LUMN) and Zayo (owned by Digital Bridge, NYSE: DBRG). In this post, we will give some background on Cogent's acquisition of Sprint Wireline, discuss the optical transport market, and finish with some thoughts on why it should create a step-change in Cogent's free cash flow profile over the coming years.
Background
Cogent recently acquired Sprint's wireline business from T-Mobile on May 1, 2023, and we think it will be transformative for the company. This acquisition brings three areas of value to Cogent:
Lightly utilized assets consisting of:
A nearly empty physical fiber network with over 19,000 route-miles of long-haul, inter-city fiber (interesting story on the network here) and over 1,200 miles of metro (intra-city) fiber.
A portfolio of technical facilities, some of which are used to run the fiber network, and 45 of which will be converted into co-location data center space with about 400,000 square feet of raised-floor space and ~50 megawatts of accessible power.
9.75m IPv4 addresses. These are currently transacting at $40-60 per address (see here for more detail).
A legacy wireline B2B business which, at closing, was generating about -$220m of free cash flow (-$190m of EBITDA, $30m of capex), but will eventually generate about $50m of free cash flow after Cogent restructures the business and extracts visible and low-risk network synergies.
$700m of cash payments from T-Mobile, comprised of $350m paid monthly in the first 12 months, and $350m paid monthly over the following 42 months.
There are many pockets of value from this acquisition, but the topic of this post is to dive into the empty long-haul fiber network. Cogent is in the process of converting the fallow, unconnected network into a national network upon which it can sell optical transport services, a large and growing >$4 billion end market driven by demand from cloud service providers, other hypserscale tech companies, content companies, and cable/telecom companies.
Now, let's walk through what optical transport is and de-mystify part of the black box within wireline B2B services.
Optical Transport - What is It?
Optical Transport (also called Wavelengths), is dedicated, point-to-point fiber-based communication between two specific locations. It is purchased as a service and operated by companies that own and operate physical fiber networks.
Buyers of optical transport need these large, dedicated pipes to connect their servers and networks at much higher service levels than could be provided by the broader internet. Sending data over wavelengths sidesteps the internet and provides dedicated, agreed-upon capacity, service levels (e.g. 100 gbps with <5 ms latency) and paths, as well as service level agreement (SLA) protocols for what happens in the event of service disruptions (this is important since the physical path is specific). It's a premium data pipe for targeted, customer-specific use cases - not for general purpose data transfers which the internet fulfills well and at much lower cost. Internet protocols look for the shortest logical hop from the current position on the way toward the end destination, but do not have SLAs on speed, latency, path, or otherwise. Cogent is one of the world’s leading internet transit companies, carrying about 25% of global internet traffic. It knows the wholesale connectivity markets well.
Wavelengths are provisioned by buying cross-connects within a carrier-neutral data center from a customer's servers (e.g. AWS) to the transport provider's (e.g. Cogent) racks in each location. Once those connections are made, the customer can move data between those two CNDC endpoints through that provider's dedicated wavelength service using Optical Transport Network (OTN) protocols.
Now, let's talk about who needs and buys wavelengths in the market:
Hyperscalers and cloud service providers buy wavelengths to connect their data centers and availability zones for large data transfers. They use a combination of metro (intra-city) and long haul (inter-city) fiber-based solutions. Sometimes they build physical fiber, sometimes they lease fiber via long-term dark fiber IRUs, and sometimes they buy optical transport services from other fiber providers.
Regional access cable/telco providers buy wavelengths to connect their "islands" of service to each other and/or to build/augment their core networks. For example, if Comcast operates network assets in the Bay Area and Los Angeles, but not the Central Valley, it would may not have contiguous network assets that connect northern and southern California. It would need to connect those "islands" of service with long-haul fiber service via owned and operated physical fiber, dark fiber leases, or wavelengths.
Other content companies (CDNs, video game companies, media companies) use wavelengths to replicate their content across different zones for faster/lower latency local delivery to end customers. Lately, Cogent has seen an influx of new demand from companies in the artificial intelligence industry which ingest enormous volumes of data to train their large language models (LLMs).
Federal, state, and local government agencies buy transport for secure file transfers outside the internet.
Some (but few) large enterprises, universities, and other major institutions use wavelengths for large file transfers between and among their campuses.
Optical Transport Suppliers and TAM
Now, let's talk about the suppliers.
The national long-haul fiber networks in the US are owned and operated by five entities: Lumen, Zayo, AT&T, Verizon, and Cogent/Sprint. Additionally, there are regional providers like Crown Castle, Cox Business, Windstream, Arelion, Frontier, and others. Vertical Systems Group shows the wavelength rankings in 2022 in the chart below (note: Cogent did not sell wavelengths in 2022):
Cogent estimates that the long-haul optical transport market is about $2 billion of annual spend and that Lumen and Zayo control 90% of the market, with Lumen being "far and away the largest." These companies don't break out their wavelength contributions specifically. In addition to long-haul, there is another >$2 billion of metro, intra-city wavelength spend to connect facilities within the same metro area. We believe Cogent will disintermediate some of that metro wavelength spend. Let's explain how and why through a series of maps.
Below is a map of Cogent's city footprint in the US, overlayed with the Sprint fiber network map (not a perfect juxtaposition of two different maps, but you get the idea). These are the markets in which Cogent has a presence in carrier-neutral data centers (CNDCs) and a map of the physical long-haul routes used to connect them. Cogent connects to about 800 facilities around the country.
Several wavelength providers can offer connectivity between Chicago and Seattle, but they may not terminate in the exact endpoints desired by the customer. In those cases, that customer will purchase a metro wavelength to connect the long-haul endpoint to its local endpoint in that market. Using an air travel analogy, it’s like having to take a connecting flight to get to downtown Chicago from O’Hare.
Let's zoom in on Chicago to get a sense for how diverse the endpoints are within a single market. Using our travel analogy, Cogent will be able to provide direct air travel to nearly all destinations - not just to the hub. This will disintermediate a portion of the short-haul, intra-city wavelength market which should provide a competitive advantage for Cogent competing against a more expensive, more technically complex, and slower provisioning solution.
We can see that Cogent offers connectivity in dozens of data centers in Chicago. The same is true for all major markets in the US. Cogent populates the most CNDCs in the country and is the most inter-connected network in the world.
Even though the total spend in the wavelength market is over $4 billion per year, we think Cogent will disrupt a portion of the metro wavelength market. It will be good for Cogent and potentially disruptive for incumbent providers.
Finally, let’s talk about typical wavelength contract terms. Wavelengths are priced based on the parameters of their SLAs - capacity, distance and path of the route, latency, and more. Prices for 100 gbps waves tend to be about $2,000-3,000/month on 1- to 3-year contracts (3 year is most popular) and 400 gbps waves tend to cost $5,000-6,000/month. Like-for-like prices decline about 10-15% per year, but customers also upgrade to higher capacity wavelengths over time as their needs evolve. The market is expected to grow in the mid- to high-single digits from a combination of volume growth (more routes) and capacity upgrades by customers (more ARPU), offset by like-for-like price reductions. Theoretically, about 1/3 of the market should be up for grabs every year, but it does seem that some growth-oriented customers (like the hyperscalers) are reluctant to switch providers, preferring instead to add capacity at every stage. It too early to know with certainty if market share will shift on contract expirations, or if share will shift primarily through share of volume growth. At this stage, our best guess would be that less than half of annual contract renewals would seriously consider switching.
Cogent's Opportunity
Cogent is repurposing the nearly-empty network it acquired from Sprint into an optical transport network. It will take some time and investment (much of which is spent already) to integrate the Cogent and Sprint assets so that all 800+ CNDCs are available for transport services, but the company expects to get there by year-end 2024. Along the way, it is already taking orders and booking wavelength contracts in the limited footprint it has today, although it will take some time to convert them into revenue given elongated installation times during the network integration phase. We believe Cogent has an opportunity to take significant share of new wavelength orders coming into the market, and also has a good chance of winning some existing routes from customers as well.
Additionally, the Sprint network has 90% physically unique paths which is important for customers that need route diversity for resilience and redundancy - especially the cloud service providers. For example, many wavelength buyers I have spoken to are excited to get access to the Chicago - Seattle route specifically because Cogent's path through North Dakota and Montana is physically unique. This means line cuts that impact one provider likely will not impact Cogent’s services. Cogent will be able to market a full nationwide network that has been built and managed almost exclusively for Sprint's first-party traffic up until this acquisition. It has routes and paths that customers are eager to access to add capacity and resilience to their networks.
For Cogent, the optical transport market alone should contribute north of $10/share of incremental free cash flow over the next 5-7 years. Cogent has guided investors to targets of linear growth to $100 million of run-rate Wavelength revenue in mid-2024 (from $8 million at closing) and $700 million of revenue in 7 years, all of which comes at 95% incremental EBITDA margins. Early demand trends have been healthier than those targets. The company already has the largest wholesale B2B sales force in the industry from its IP transit business and it has relationships with all the major customers that buy optical transport services. This is a rare and unique opportunity for a company to create a step-change in growth from a completely new but adjacent, non-cannibalistic business - all at a negative cost basis due to T-Mobile's cash payments.
Cogent's run-rate revenue targets imply about 3,000-3,500 wavelength contracts for $100m of revenue (at ~$2,500 average MRR per wave) and 20,000-25,000 wavelength contracts for $700m of revenue. It sounds like a lot, but it will be able to sell n(n-1)/2 unique routes, where n is equal to the number of connected CNDCs. Cogent will have about 320,000 unique point-to-point routes available for sale.
Looking at it from a selling perspective, Cogent has about 250 reps that sell to wholesale buyers of connectivity. If each rep sells one net new wavelength contract per month (again, at $2,500/month of MRR), Cogent would be booking $7.5 million of annual recurring revenue (ARR) per month, or about $90 million or ARR per year. Lately, reps have been selling and installing 4-5 services per month (across the product portfolio), but there have been periods when they averaged 6-7 services per rep per month. This assumes no growth in the sales force, but it tends to grow MSD to HSD annually. In short, Cogent has the sales rep capacity to handle another 1-2 wavelengths per rep per month which would allow the company to reach its targets.
Of course, it's easy to look at spreadsheet math and see how much cash flow can be generated from this market. It's important to remember that Cogent must first cross some key milestones in its network integration with Sprint's fiber network before it can access the whole market. Significant progress will be made over the course of the next 12-18 months, at which point Cogent's wavelength offering should be at the peak of its disruptive powers. Once fully integrated, Cogent should be able to win on various dimensions. Below we outline the company’s competitive advantages:
It will be able to provision wavelengths faster (2 weeks vs. 3-9 months for competitors).
It will have a more ubiquitous network with full distribution to 800 CNDCs (vs. 350 for Zayo and Lumen)
It provides network resilience from its 90% unique physical paths
It entered this business at a negative cost basis and will never be undersold
It has the largest and most aggressive sales force in the wholesale connectivity market
Closing
We love to find the structurally faster/better/cheaper, disruptive companies in their end markets because if our understanding of their advantages are correct, there is significant market share to gain. Cogent already is faster/better/cheaper and disruptive in its classic Cogent markets, but this acquisition gives it access to another avenue of growth that should be easier to penetrate given its existing business, brand, and customer relationships. We hope this post provided some helpful insights into the exciting opportunity in front of Cogent over the coming years.
Until next time! - EP