Virtu Financial, Inc. Q3 FY2022 Earnings Call

Good morning, and thank you for joining the Virtu Financial 2022 Third Quarter Results. Please note that this conference call is being recorded and will be available on the company's website for replay shortly. And now I will turn the call over to Andrew Smith.

Thank you, and good morning, everyone. Thank you for joining us. Our third quarter results were released this morning and are available on our website. On this morning's call, we have Mr. Douglas Cifu, our Chief Executive Officer; Mr. Joseph Molluso, our Co-President and Co-Chief Operating Officer; Mr. Sean Galvin, our Chief Financial Officer; and Ms. Cindy Lee, our Deputy Chief Financial Officer. We will begin with prepared remarks and take your questions. First, a few reminders. Today's call may include forward-looking statements, which represent Virtu's current beliefs regarding future events and are therefore subject to risks, assumptions and uncertainties, which may be outside the company's control. Please note that our actual results and financial conditions may differ materially from what is indicated in these forward-looking statements. It is important to note that any forward-looking statements made on this call are based on information presently available to the company, and we should not undertake to update or revise any forward-looking statements as new information becomes available.

Thank you, Andrew, and good morning, everyone. This morning, we reported our third quarter results. For the quarter ended September 30, we generated $0.61 of adjusted EPS and $5.2 million per day of adjusted net trading income, bringing our year-to-date results to $2.61 per share and an average adjusted net trading income of $6.3 million per day. Our business performed well against the opportunity presented for both Market Making and institutional flows, with both exceeding our internal opportunity benchmarks. Our results enabled us to consistently return capital to our shareholders through our share repurchases. As of today, we have repurchased a total of 31.1 million shares or over $870 million in aggregate, and at current levels, we will continue to be aggressive in repurchasing our shares with about $350 million of remaining capacity. Our investments in our growth initiatives continue to return impressive results, accounting for 15% of our adjusted net trading income for the quarter, up from 7% in 2020 and 2021. Options remains a significant long-term growth driver for us, not just in the U.S. or even just in equities. Our scaled approach means we're already finding ways to deploy what we are learning in U.S. equity options into opportunities abroad and in other asset classes. Speaking of scale, as we grow in options, that will expand our competitive scale in other asset classes, including wholesale equities, as well as potentially presenting opportunities for us to add options capabilities to our global execution services footprint, including algorithms, workflow, and analytics based on client demand. For now, being competitive in options requires significant investment in technology and people to ensure that we have adequate capacity to meet our goals. We continue to make methodical progress in expanding our universe and increasing our interactions with order flow from options drivers. Our growth in options year-to-date is especially impressive given the market-wide options volumes are relatively flat compared to the same period. Our growth initiatives to expand into crypto market making have continued to progress since we spoke last quarter. Our growing crypto desk remains focused on developing connectivity and technology to a growing number of the top crypto venues as we work to expand the opportunity that we can address in Bitcoin, Ethereum, and other top cryptocurrencies across various forms, including spot, ETFs, and futures. Our venture with Citadel, Fidelity, Schwab, Sequoia, and Paradigm to develop a crypto ecosystem to serve the interests of global investors is proceeding nicely. Our global ETF block initiative also continues to contribute to our results as we focus on growing our footprint in the fixed income ETF universe in conjunction with key investments we're making to become a dealer in the market for corporate bonds. Before I turn it over to the financial view, I'd like to talk about market structure, what's currently being considered by the SEC, and our efforts to provide facts and data to the public discourse. We believe a positive element of the adequacy work we're conducting is creating a broader understanding of the extraordinary value that the current competitive ecosystem provides to retail investors. There are a number of points worth highlighting about market structure. First, I want to be very clear that while there are still no official proposals from the SEC, it would likely be years before certain ideas are proposed, adopted and become effective rules. Virtu remains publicly supportive of several of the concepts discussed by Chair Gary Gensler during his June 8 speech. Specifically, we agree that exchanges should be able to display more quotes, especially half-penny quotes, with tick constrained symbols; some of the quotes should be included in our Systematic Internalizer and disclosures in retail execution quality reports, and Rule 605 should be modernized, as we requested in our official petition for rule-making, which we submitted over a year ago. That said, historically, SEC rule proposals with the potential for substantial market impacts have followed a deliberate multiyear process of content release, roundtables, and other forms of industry engagement designed to solicit broad and substantive feedback on particular marketplace themes. These processes help ensure that any final proposals resulting from this exercise are responsive to actual marketplace challenges and enjoy broad support across a range of market participants. Effective and efficient rulemaking is a methodical process. Doing it right takes time, and benefits from experienced staff at the SEC being involved. This is why the SEC documented its own processes, procedures and requirements for rulemaking. Unfortunately, as was recently reported by the SEC's own Inspector General, the current chair and his political appointees tend to prioritize speed over accuracy, and as the SEC's Inspector General stated, they lack the resources to keep up with their self-appointed agenda, potentially at the risk of adherence to the agency's own processes and ultimately the rule of law. The SEC's unchecked speed and lack of resources is particularly worrisome to a broad range of market participants and investors, including hundreds of our clients, given that the SEC has assigned itself an ambitious agenda with numerous interrelated market structure reforms that could significantly and permanently alter our efficient, accessible, and resilient financial markets. Despite the industry's general agreement around where the SEC should focus its efforts, the chair's repeated misstatements about facts regarding retail order routing practices and payment for order flow provide little comfort that the staff are empowered to listen to industry feedback or are incorporating readily available data into their decision-making processes, but are instead engaged in what a prominent life science commentator noted this week as regulation by hypothesis. We support Schwab's comment in its recent white paper that the U.S. equity markets are the deepest, most liquid, and most efficient in the world, which allows investors to enjoy narrow spreads, low transaction costs, and fast execution speed. We echo Schwab's concern that the SEC's call for reform could undermine the benefits of the current ecosystem to retail investors. Furthermore, we are alarmed by the current SEC's positions that reflect deviations from the agency's long-standing goals of enhancing and protecting the retail investor experience. We remain committed to engaging with the SEC in hopes they will embrace the constructive engagement that the industry continues to offer to advance policies that enhance transparency, competition, and investor choice while promoting superior execution quality rather than the SEC's politically motivated agenda. I will now turn the call over to Joe.

Thank you, Doug. Based on the guidance we have previously provided, we are on pace to meet or exceed our target buybacks and financial earnings ranges for the year. Given the opportunistic refinancing we completed back in the first quarter, we would anticipate share repurchases to correspond with the previously shared public buyback ranges for the foreseeable future. As was mentioned above, we have generated an average of $6.3 million per day in adjusted net trading income through September 30, totaling $2.61 in adjusted EPS and $733 million in adjusted EBITDA, both on target with the ranges provided. As we said in the past, we believe the range of outcomes is sustainable throughout the cycle as these levels are a result of significant growth we have achieved to date to raise our baseline performance over the years, both organically and through acquisitions. Consistent with our ethos of disciplined expense management, we have successfully held costs in line despite the worst inflation since the 1970s, producing a 61% EBITDA margin year-to-date. As Doug mentioned, we remain committed to returning capital to our shareholders through our current quarterly dividend and the share repurchase program. Since the inception of the share repurchase program, we have repurchased 12.2% of Virtu shares, net of new shares issued for employee compensation. We have a long-term perspective and will continue to repurchase our shares in the quarters with the ranges that we have previously shared. Touching on the performance of our segments: Market Making performed as expected. Broad measures of overall and retail volumes versus the second quarter were down materially. Average realized and applied volatility were down 25% and 10% respectively. U.S. equity share volume in notional value trading were down 13% and 22% respectively. Average daily shares have IBKR, which is a proxy for retail activity, were down 9%. Rule 605 share volume in the third quarter was down 5%. All in all, our diversified Market Making business performed well against this environment. Our Execution Services business also performed in line with the market opportunity this quarter, realizing $93 million in adjusted net trading income. It's important to note that in a quarter such as this, the multiyear integration of the XITT platform, in particular, that we recently completed allows us to maintain, invest, and provide critical services to clients in a less than robust environment. We have overhauled and replatformed our technology in the Algo product suite, reduced costs dramatically, and retained our broad blue-chip client base. Now I'll turn it to Sean to wrap up the discussion.

Thank you, Joe. In the third quarter, as presented on Slide 2 of our supplemental materials, our adjusted net trading income, which represents our trading gains, net of trading expenses, totaled $331 million or $5.2 million per day, which is 7% lower than Q3 2021 and 10% below the second quarter. Market Making adjusted net trading income was $238 million or $3.7 million per day, 4% lower than the year-ago quarter and 9% below the second quarter. Execution Services adjusted net trading income was $93 million or $1.5 million per day, which is a 12% decrease year-over-year and a 13% decrease from the second quarter. Adjusted EPS was $0.61 for the third quarter. For the third quarter, our overall compensation expense was $103 million, which is up slightly from the second quarter. Our Q3 cash and overall compensation ratios were 25% and 31% of adjusted net trading income respectively, and were 21% and 25% year-to-date. Adjusted EBITDA was $181 million for Q3, which was down 14% from both the prior year quarter and the second quarter of 2022. Our adjusted EBITDA margin was 55% for the third quarter, down 4 points on the second quarter, but continues to be reflective of our efficient cost structure and disciplined expense management. Our capitalization remains adequate and our long-term debt was $1.2 billion at quarter end, which reflects a debt to trailing EBITDA ratio of 1.7x. Finance and interest expense was $23 million for the third quarter of 2022 compared to $20 million for the prior year third quarter. We remain committed to our $0.24 per quarter dividend, which we have consistently paid over 29 quarters in every environment since our IPO, and our approximately $432 million share repurchase year-to-date demonstrates our continued commitment to return capital to our shareholders. I will now turn the call back over to the operator for Q&A.

The first question from the phone line comes from Rich Repetto of Piper Sandler.

So I guess the first question is, you pointed investors towards looking at normalized earnings. And just trying to understand, over the last 8 quarters, you've averaged over $1 in EPS per quarter. The last couple of quarters have been a little bit lower. But I guess what's your view on what normalized earnings are? Are the recent quarters more sort of the trend of what retail flow should be like going forward? Or do you still expect the outsized quarters just from sort of event-driven volatility?

Rich, it's Joe. Look, I think the answer to that question is that the slide that we put in, we don't have it in this quarter because it was just so repetitive, so I'll read out into it. But you're right. I mean, through the cycle, we think we're going to wind up on that page, right? We had $6 million on that page as the lowest number, and I think we are at $6.3 year-to-date. I wouldn't read anything into the last 2 quarters as a view on the future in terms of retail participation, in terms of the institutional business, in terms of the prop business. It's just part of the cycle, right? And I think that our long-term goal is to continue to kind of move down that page, move from 6% to 6.5%, 7% up the chart by growing the business and by buying back shares. We bought back an eighth of the company over the past 20 months or so, and I think that's incredibly powerful. The buyback ranges that are in that slide, again, we didn't repeat it here, but you guys should use those as the future state looking at where we are. And we're interested in continuing to grow through it. It's nothing more than that.

I have a follow-up question regarding regulation. Doug, you were quite emphatic in your prepared remarks. Now that it's been reported in the media that a bid on payment order flow is no longer an option, could you address your stance on tick size adjustments and order-by-order competition? I believe those two factors are still significant issues to consider moving forward.

Right. Thank you for the question. As I indicated in my prepared remarks, we've been very proactive, and we put a rule-making proposal in over a year ago on several topics that we would be very supportive of that has universal or near-universal support around the industry. Obviously, some of the nuances need to be addressed, and there was a simple roundtable on September 13, ironically held in Washington D.C., that the entire industry was there, other than the SEC, which probably should have been there. And I think there was universal support for the topics discussed including transparency and disclosures, so that investors can understand the impact of size improvement and perhaps further disclosure around the amounts of rebates that are being paid to some brokers regarding tick size. I think it's very important. Again, this is something that the Chair, mentioned which is that today, ATSs and exchanges can execute at sub-penny prices. There's no restrictions on that. So there are retail liquidity programs on national securities exchanges right now where executions can and do occur at sub-penny prices. So in terms of leveling the playing field, there's no reason that one of the 17 national securities exchanges can't encourage the execution of retail market orders at sub-penny prices; they happen today. What we did discuss regarding transparency is that there are a significant number of stocks where ample liquidity exists at either side of the touch, and there exists significant demand for midpoint executions that are actually done either in dark pools or on exchanges. So we're in favor of several things along those lines. In terms of payment order flow and what the chair refers to as order-by-order execution without any detail, we've been very proactive on that, but there's just a fundamental lack of understanding by the Chair about how the entire ecosystem works, that there is competition for every order, and it is a very wholesome competition between 8 or 9 different wholesalers. The benefits of price improvement is overwhelmingly significant and data-driven. If you look at the Schwab white paper, they talk about $120 billion of price improvement over the next 10 years. To aggregate the responsibility of the wholesale and essentially take any order that comes to the wholesaler would damage that ecosystem, in our view, and frankly, in the view of all the wholesalers. So today, investors have choices. They can send their orders to a retail broker that accepts payment for order flow, and there are hundreds that do not. They can send orders to brokers that use wholesalers, ATSs, and exchanges. There are retail brokers that are stating they will not send orders to wholesalers. In my view, and I think in the view of people that appreciate competition in a free market, all the things that the Chair wants are out there. If an ATS or an exchange wants to create an option, there are a couple out there; they can create one. If the retail broker believes that they can get better execution by sending their orders to an option, they will do so. When regulators and this Chair, in particular, start talking about picking winners and losers in the marketplace, that's where I think they go astray. That regulation by hypothesis and not by allowing free market competition to work, and that's why we will continue to be very data-driven and outspoken on this issue because we do not believe it is consistent with how markets should function. If the Chair really thinks that the markets would be better with an auction option, then introduce a pilot program, collect data, and assess execution quality. Otherwise, changing an entire market structure or attempting to do it based on hypothesis alone is nonsensical and inconsistent with the policies and procedures of the SEC and certainly would not stand under The Administrative Procedures Act. This sentiment is shared by dozens of firms.

We now have Chris Allen from Citi.

I want to talk a little bit about expenses. And just some of the different adjusted OpEx lines. Cash comp ratio is up to 25%, which is high relative to prior quarters. But on an absolute dollar basis, it looks like it's pretty steady. Just wondering if that's being driven by the adjusted cash operation, we should be thinking about it from a percentage perspective or just in terms of the run rate from a dollar perspective moving forward. And then just in some of the other lines, where are you from a scale perspective, looking at G&A specifically, any factors that are going to deviate or drive the run rate higher from here? Are you fully built out and do you have capacity in areas like options and things like that, or do you need to build out further?

Yes. Thanks, Chris. On comp, it's a really simple story. We have been accruing flat, and during the third quarter, we are going to look at the year-to-date ratio, right? So the flat accrual generated a 21% cash comp ratio year-to-date, and we're very comfortable there. If you look historically, that's right in the zone and you shouldn't expect too much of a deviation from that. Depending on where we come out on revenues, obviously. But we've always oscillated between kind of the high teens and low 20s on a cash comp ratio and we shouldn't deviate from that too much. I wouldn't expect it to be higher this quarter. This quarter is just a consequence of net trading income in Q1 at 17%, Q2 at 22%. So we're kind of 21% year-to-date. In terms of your other question, the good thing about the growth initiatives is, I think a lot of the investment is kind of done and behind us. I mean, we're in data processing line, and I think we're in the right kind of accrual range there. You should see things similar going forward. So I wouldn't expect any surprises on OpEx. Obviously, administration fluctuates. There are some things that are causing that to go up like everything else, things that we paid for like insurance rates that go up, and there are some things that help us in there. We've got foreign subsidiaries and paid bills in different currencies, and some dollar exchange rates help a little bit there. But there's not too much noise and I wouldn't read too much into it. When I look at our quarterly expenses over the past several quarters, considering the inflationary environment we’re in, I think that’s a pretty good story there in terms of holding the line.

Cool, maybe just a quick follow-up on just options. Just wondering where you are and your capabilities there from an infrastructure perspective. Is everything fully developed, your quoting system fully developed? Is it now just basically blocking and tackling in terms of adding symbols or is there more to be done in terms of building out your capabilities there?

Yes, it's a great question. It's kind of a hard one to answer. I don't think you've ever really fully developed and fully done with anything, even within U.S. equities, which obviously we've been in for 15 years. I'm not trying to avoid answering the question, but yes, there’s continuing development work in options. We have a very robust infrastructure that allows us to quote any options and be profitable, which we are in all the U.S. options contracts we trade. We're connected to the options venues. But obviously, there’s a lot of blocking and tackling needed in some very new and different asset classes for us. We have made some great strides in terms of the symbols where we are competitive and taking the first steps towards taking retail order flow by taking options contracts off options drivers. The good news is, as I noted in my prepared remarks, once we have built that scale to pivot to options beyond equities is very easy, because we have connectivity and excellence in a lot of experience in commodities and FX, et cetera. So in terms of where we are, it's very early, and we're in the second inning regarding opportunity. The good news is that from a scale, infrastructure, and relationships with exchanges, we're in the late stages. But as I said, there’s always work to be done, and I’m very, very happy with the progress that the group has made globally.

We now have Ken Worthington from JPMorgan.

The Virtu new initiatives have been about 10% of NTI for the last 3 quarters. Why has this been so stable this year as you continue to build out the options and crypto initiatives rather than showing either steady or episodic growth so far this year? And maybe you can highlight the major milestones you see for the crypto and options build out over the next 2 or 3 quarters.

Ken, it's Joe. I think the 10% number really reflects where we come out overall in net trading income. It has been pretty steady. There are new initiatives in that they're greenfield and that they were only a handful of years ago. We generated this quarter $0.5 million a day. But they are subject to the same kind of volatility that the rest of our business is. So I wouldn't read into the 10%. I mean, I think Doug just went through some of the milestones in options in terms of building the business at scale and going for a broader set of symbols. In crypto, I think it's still early days; it's probably even earlier than what Doug mentioned in terms of options. We're connected to multiple venues. We are trading in multiple coins. We are approaching it in Virtu's way, being very incremental about it.

Okay. I guess maybe just to follow up on that. If you're having success in these build-outs, I would think that they would be a bigger part of your franchise over time. They don't seem to be. Is this maybe pricing where you're building the business, but it’s not necessarily translating proportionally into earnings right now or NTI right now, but it will in the coming quarters? I guess I'm just trying to connect those dots.

So yes, I wouldn't read too much into the percentages. You're comparing greenfield businesses that are growing, yet are still subscale, to more developed fully scaled businesses. The good news is that our non-growth initiatives had a really nice quarter; they outperformed our metrics. So relative, if the numerator is improving and the denominator is improving, that's probably good news. The denominator, our non-core business, which we do not break out, outperformed the metrics. The growth initiatives have expanded, but they are obviously subject to market conditions. The fact that they kept pace with the rest of the business, which performed well, outperformed our internal metrics, is a positive sign.

Another way to say it is that if the non-organic revenues had declined, or deteriorated, the percentage of NTI would be a lot higher, but that wouldn't be favorable. We would have denominators decline, and you all would be even more unhappy.

Our next question comes from Daniel Fannon with Jefferies.

I have a question, Joe, about the buyback. The year-to-date numbers are tracking close to $430 million, which is considerably above the normal sensitivity tables. You mentioned the debt paydown as a contributing factor. As we look toward the fourth quarter and beyond, what do you consider to be the normalized level we should reference? It seems to not align with the NTI numbers.

Yes. That is a very good question. I think the year-to-date number is well above that range because of the financing we did in Q1. We took the opportunity to dedicate some of those excess proceeds to the buyback. I think going forward, you should refer to those buyback ranges that correspond to the NTI per day and hold us to be within those ranges. We’ll be talking more hopefully to the midpoint or higher in those ranges, but that’s the way to look at it.

Understood. I guess just even for this quarter, you did that in the first quarter, but obviously even this quarter, your number is quite higher. So if we just annualize the NTI for 3Q versus what you bought back, so is that benefit from the financing done and that still pulled through this quarter as well?

So a little bit. We also had some realizations from some of these investments that we had done as part of market structure initiatives where we get involved and use some of those proceeds. We did this transaction with market access with our Q-hub, and we did a transaction. So some of those proceeds helped along the way. Again, our view is we have more than adequate capital to run the firm. We have a debt level in place that's sustainable through any cycle, and that's on that range and everything else will be returned to shareholders. You have two factors this year — the investment proceeds and the debt refinancing proceeds. But going forward, we will use those public buyback ranges.

Our next question comes from Alex Blostein of Goldman Sachs.

Maybe a little bit of a bigger picture question, Doug, for you, just around the market quality. We continue to hear liquidity concerns in various pockets of the financial ecosystem. You guys obviously participate in many different asset classes around the world. Any different areas of concern you see from just a market structure and a market quality perspective? Any particular asset class that you would highlight in light of those, or are you augmenting your trading and behavior activities?

Yes, it’s actually a great question. I think within global equities, there is, for the most part, adequate liquidity. Certainly, as you go out on the skew to stocks that possibly institutional investors are not quite interested in, again, to continue to beat this very dead horse, absent wholesalers and the obligations we have to our retail clients, there truly would not be adequate liquidity. Many of our institutional clients come to me and say this narrative that retail institutions can interact is inaccurate because we are not interested in stock under $5 that trades 200,000 shares a day. So when those orders come down the pipe, Virtu, Citadel, Susquehanna overall have to take them and provide liquidity. In terms of a more macro view, we echo and share some of the concerns in the fixed income market, not just with active charges, but off-the-run treasuries, where there is not the same level of big dealer participation. That is regulatorily driven. Unfortunately, bad facts result in bad law which creates bad outcomes, and then the government scratches their heads and asks how come banks aren’t holding the inventory when you told them not to and you charge them a lot for it. That said, we were motivated to step in; our footprint in the fixed income ETF and credit trading business has grown significantly. Five years ago, I would not have thought Virtu would be a dealer on market access, which we are now. I also would not have believed Virtu would be able to price and create bespoke fixed income ETFs, but we do, and it’s clear that firms like us have stepped into the void created by this regulatory environment, creating an opportunity for us.

Got it. Super helpful. My second question is a little more strategic. I was hoping you could unpack the dynamic between trading revenues and cost of trading this quarter, particularly on the Market Making side. I guess we can look at some of the disclosure you guys provide in the back, the trading income I think is flattish quarter-over-quarter, but payment for order flow was up, I want to say in the teens, again, sequentially. Typically, these two can move together. So maybe just give us a sense of what's been driving divergence this quarter. Is it just higher margin requirements and maybe higher interest rates charged by the FCMs and prime brokers? And how should we think about that relationship going forward?

It's not the latter. It's just more of what you were kind of alluding to before and former. It's just a mix of business. It's just a mix of business between platform market making and customer market making and execution services.

Okay. Within asset classes, right? Because on the execution services, I think it was fairly consistent, but the divergence was largely on the Market Making?

Correct. Exactly. It's just a mix of business.

Thank you so much, and thank you, everybody, for participating today. We hope you all enjoy the end of your year, and we look forward to chatting with you in late January or early February. Thank you. Have a great day.

Thank you all for joining. That concludes today's call. Please enjoy your day. You may now disconnect your lines.