Flow Traders N.V. is a leading global technology-enabled liquidity provider, specialized in Exchange Traded Products (ETPs) that massively profits from the ongoing trend to passive investments (read more in my prior post). As such, it could benefit tremendously in the years and decades to come leveraging its technology and its growing global presence. This post will analyse Flow Traders potential in more detail …
Since Blackrock, the other company related to the trend to passive investments, is much bigger market cap-wise and very likely has more analysts/investors following it, I believe there might be more value in analyzing Flow Traders (first).
This is not investment advice. Please read the disclaimer.
Flow Traders quotes bid and ask prices in thousands of ETP listings and other financial products and describes itself as a financial technology company using its proprietary technology platform to provide liquidity to institutional counterparties. It was founded in 2004 and is based in Amsterdam, Netherlands. You find a company video here.
It appears to be a young and modern company within the financial industry offering some start-up flair for like-minded employees. This set-up could enable Flow Traders to
be more agile act faster, develop better technology and capture opportunitites more effectively than competitors.
Aligned incentives seem to be ensured through high share ownership of insiders, overall. The two co-founders Jan van Kuijk (12%) and Roger Hodenius (10%) own a significant amount of shares and are members of the supervisory boards, nowadays. Additionally, employees own some shares and are strongly incentivized through variable renumeration depending on profits. I would like cheif executives and key persons to own more shares, though.
More recently, Flow Traders share price traded higher (unsurprisingly) as it earned a lot of money with market volatility being at elevated levels (resulting in higher spreads), showing its attractiveness as a portfolio hedge. Flow Traders (FLOW NA) shares’ price rose from € 20 in February to € 34 in July. The interesting question for me that I want to answer eventually is:
What is Flow Traders fair value
based on long-term average market trends?
Product segments can broadly be defined as ETP and non-ETP products, but reporting is not very detailed with regard to product categories. ETPs and Flows business model is explained in detail on pages 8ff in their 2019 annual report.
Exchange traded products or ETPs mostly track an index without trying to beat such indices in a cost-efficient way. Products can be grouped as Funds (ETFs), Commodities (ETCs) and Notes (ETNs). ETNs are issued by banks and promise (thus default risk) a performance based on underlying securities. ETPs can be traded throughout an extended trading day. ETPs have a transparent fund structure, disclosing holdings and weights (giving Flow the possibility to hedge its exposure almost perfectly).
The primary market takes place between authorized participants (APs) and the issuers (i.e. BackRock), who either issue or cancel ETPs. The APs can be viewed as providing the trading technology as a service to the issuers which is non-core to them.
The secondary market is where ETP trading takes place between market participants at market-determined prices via exchanges and other automated trading venues, as well as off-exchange between market participants such as large institutional investors. Participants are institutional and retail investors, liquidity providers and APs.
Flow expands non-ETP trading capabilities in Europe, mostly consisting of FICC instruments (plus crypto). This is important not just pushing Flow’s non-ETP value traded (and NTI) , but in improving ETP pricing and hedging capabilitites. Flow further builds its EMEA ecosystem leveraging its existing technology: trading more products with more counterparties.
Regional segmentation follows a common logic and are defined as Europe or EMEA, the Americas (mostly the US) and Asia or APAC. Huge differences persist between the three regions, but …
All regions are profitable.Dennis Dijkstra, 2019 results call, p9
In EMEA, Flow has a very high market share of about a third of the ETP market value traded. Flow benefitted strongly from MiFID II developments (mainly best execution for investment clients). Flow has established a connection with virtually all ETP issuers active in Europe and continues to grow its institutional counterparty-base. It grows in non-ETP asset classes as well. Anyway, the total ETP value traded in Europe is comparatively small (Q2: € 480 bn), only representing 5.2% of the global volume (€ 9.2 tn). FT’s European NTI margins are lower than in Asia but higher than in the US.
In the Americas, Flow’s ETP value traded remains limited (€ 452 bn) compared to the huge overall US market size (€ 20.1 tn). The US market is highly competitive and regulatory measures like MiFID II in Europe are not to be found (yet) but Flow’s growth potential could be enormous, if regulation leads to a more level playing field. Besides that, expanding its ETP ecosystem (counterparties, venues, products) should lead to growing market shares.
In Asia, Flow wants to expand into new markets. Keeping a strong focus on markets that are potentially opening up, such as China, is key. The Asian ETP market remained fragmented with regard to trading volumes, trading costs, regulation and market maturity. Ten dominating ETP products determine roughly 55 percent to 65 percent of the total Asian market volumes. All trading desks for on-screen liquidity provision were moved to Hong Kong.
Technology truly lies at the heart of Flows opeartions. Most employees (40%) work in the technology department, which develops most of the used software. Technology invesmtents will probably stay at a high level, since the indutry is very competitive. This industry setting indicates that Flow Traders has no moat or in a positive scenario Flow probably has …
A narrow moat consisting of a broad ETP ecosystem (products, counterparties, venues) with top-notch proprietary trading technology can be attributed to Flow Traders, based on my current view. The business might be comparable to a cyclical commodities business, since profits very much depend on market factors (for FT: market volatility and ETP velocity instead of commodity prices). Hightened competition and technological advances could constantly pressure average margins during periods with low volatility.
Managing risk is important for financial companies. Flow Traders does not trade on the basis of a directional market opinion, but purely profits from spreads between the bid and ask quotes, trading for its own account and risk. Thus it is paramount to have a high-quality risk-management in place, which seems to be the case: The company recorded no loss-days in FY 2019 (p10) or Q1 2020 (#6), which I find very reassuring (as a potential investor).
Maintaining a strong capital base besides daily risk management operations will enable Flow to grow going forward.
Net trading income or NTI is nothing else than gross profit for Flow Traders as usual for financial firms, there is no revenue line to be found in the income statement. NTI is driven by Flow Traders’ or (i) FT value traded and its (ii) NTI margin earned on that volume on average.
(i) FTs value traded is mostly dependend on the market value traded and FTs market share. The former is driven by assets under management or AuM and velocity (itself driven by volatility or vola), whereas the latter is driven by the number of counterparties and venues as well as pricing capabilities (technology). AuM should grow for years to come and could be modeld as a function of (a) capital inflows and (b) asset price performance in the longer-term. I believe there could be above average growth for (a) inflows in the European market where FT has a strong position.
MiFID II was a huge benefit for Flow Traders in the EMEA region. Currently there is some chatter, that some aspects of the regulation will be rolled back. This could adversely affect Flow Traders ETP value traded in Europe.
(ii) FTs NTI margin results from profit per trade after hedging resulting exposure and is positively correlated with market volatility. Working in a trading environment, I can tell you first hand that when market volatility rises, bid-ask-spreads, trading activity (velocity) and trading profits tend to rise. High volatility levels lead to vast NTI margin expansion for FT, as could be seen in Q1 2020 (to the right end of the below chart) and many periods before that (see 2019 ar, p 19). FT’s NTI margin is much higher in Asia compared to Europe and especially compared to the US.
The key drivers for NTI can be illustrated like below, I believe. In the short-term, value traded (driven through velocity) and especially margin (driven through vola) is quite uncertain. However, longer term, market value traded (esp. in EMEA) should almost certainly increase (driven through AuM) and believing in a positive case, there is a good chance for FT increasing market shares in the US and Asia. It is reasonable to expect NTI margin to fluctuate dramatically, being subject to cyclical swings in market volatility. To anticipate a likely outcomne of this outcome: I believe it is important not to buy Flow when volatility is high, but to wait for lower volatility levels (interesting coincidence: I just finished the book mastering the market cycle).
Flow Traders’ strength is its global ETP footprint, or so they state in the 2019 results call (p5). As can be seen at the top of the slide 10, FT has consistently connected to more and more venues and counterparties, which enabled them to increase ETP Value Traded. However, regional differences persists …
Europe is where Flow Traders is headquartered and its strongest market. Trading moved away from dark pools to multilateral trading facilities or MTFs (read more here) following the regulatory introduction of MiFID II. This trend has been a real positive for Flow Traders, and FT now sees almost all the flows which has a significant impact on our pricing capabilities. We have a leading market position, and our on-screen market share is regularly in the 35-plus region. Critically, we are successfully building on and expanding this market position. The nature of the European market and concentration of market share has led to the withdrawal of certain smaller competitors.
The US market is the largest ETP market globally and crucially has a single regulatory regime. Technology, including RFQ adoption and regulatory changes such as unbuilding and best execution will create a more level playing field, and this is an opportunity for Flow Traders. We are seeing a growth in more transparent OTC trading platforms with best execution becoming more prevalent. FT’s position in the US is more nascent, and is very much about investment and growth. FT is already top three in OTC trading. More products and onboarding additional counterparties will generate more flow and improve pricing capabilities.
Asia is the second largest regional ETP market and is dominated by China. Asia has a slightly fragmented landscape, and this is also very much a growth market. Flow Traders currently operates in Asia ex-China. From a competitive perspective, there is a high degree of relationship-driven trading in China led by domestic banks who indeed often are also ETP issuers themselves. FT examines entering the Chinese market given its size and importance.
Product-wise, Flow wants to leverage its strengths in ETP products to grow in non-ETP product categories as fixed income and currency products. Fixed income trading capabilites should again drive fixed income ETP trading. BlackRock predicts bond ETFs assets to double with institutional investors increasingly embracing fixed-income ETFs.
Flow’s dividend policy is to pay out a minimum of 50% of their net profits annually in two dividend installments, according to their ar 2019, p14. This reflects capital requirements for a growing financial services businesses and limited investment opportunities for cash. Besides some IT invest, acquisitions could represent an opportunity but might deliver inferior results based on Flow’s proprietary technology. I believe, this policy is a sensible us of capital.
Dividend payments have been about one to two Euros annually since 2016. For 2020 these could easily reach two to three Euros follwed by a high interim dividend in 2021.
Operating costs are mostly made up of fixed and variable employee costs, technology expenses and some other costs. The variable costs should also do a great deal to incentivize employees to maximize profits and decrease the operational leverage. Fixed costs should slowly increase with operations (offices, employees, …) going forward. Total employees did decrease durint hte first 3 months in 2020 and are down from 513 FTEs to 503. Flow Traders guides to a maximum increase of 10% in fixed costs. This growth rate should come down over time.
Skin in the Game
Renumeration policy and employee share holdings are reported on page 29 of the ar 2019. Variable employee expenses are payed out over several years and the retained amounts partly serve as additional loss absorbtion buffers (additional capital). This setting lowers risk and motivates employees to deliver good results (at reasonable risk levels).
Bringig it Toghether
i) Global AuM in ETP products should grow for many years to come, caused by enticing product advantages for investors (cheap, diversified benchmark exposure). I expect significant fluctuations, driven by in- and outflows as well as market performance (prices), but the long-term directional trend is very obvious to me. The only question is how strong will the growth in ETP AuM be. Below is a slide from BlackRock from 2018, discussing ETF growth (as a subset of total ETP market):
ii) Trading activity might come down a peg or two for ‘normal periods’ if a higher share of investors applys more of a buy-and-hold approach. This should lead to higher market ETP value traded in average years (still very high for Q2).
iii) Flow should capture a higher market share of a growing total market ETP value traded assuming European ETP AuMs will grow above average and Flow maintains its high EMEA market share supported by its strong ecosystem. European retail investors adopt ETFs and institutional investors’ demand for fixed income ETPs grows. Outside of Europe, Flow Traders grows its ETP ecosystem and market presence and is set to winn market share as well (starting from a low basis). Growing its ecosystem is the factor most controllabe by the company. Additionally, the international playing field could develop in a very favorable direction if certain regulation is introduced.
iv) Market volatility as the driving force for the FT’s NTI margin is completely out of the company’s control but it is responsible for outsized profits (i.e. Q1). Longer-term, market volatility levels will most certainly be lower compared to current levels — but irregular dramatic spikes in volatility every x years are not to be ruled out. With more technology and algo trading involved nowadays, a good argument can be made for periods with extreme market volatility occuring more frequently in the future. This VIX spikes drive NTI profits seasonality (moderated through variable renumeration) through higher market trading value and elevated margins. The effect of market volatility on Flow’s profitability can hardly be overstated (stars below), but uncontrollable.
Expanding its business in Asia after building necessary local relationships (see strategy), could result in a nice uplift for Flow Traders total NTI margin. In contrast, a higher market share in the more competitive US market would most likely have a dilutive effect on NTI margins, but could turbo charge FTs ETP value traded, still leading to higher profits.
Buying cyclical companies at cyclical bottoms, appears to be the more profitable strategy in general. But currently, the cycle for Flow Traders or more specifically Flow’s NTI, driven by market volatility, is certainly not at a cyclical low. Below I will present my unsophisticated model to derive an estimate of a fair value range.
A Range of Valuations
I assume a terminal growth rate of 3% after 2030 and I apply a discount rate of 8% to modeled net profits, but these annual net profits only partially flow to shareholders via dividends (and buybacks). Earnings are retained as well, supporting higher capital requirements from the growing business. Net profits only result from an NTI margin earned on ETP value traded. I exclude results of the current fiscal year.
a. A first quick valuation results in an estimated fair equity value of € 825m, using assumptions that I believe will turn out as too conservative. I assumed ETP AuMs growing at a CAGR of 5.4% only, resulting in AuMs of $ 10 trn in 2030, up from 5.6 in Dec 2019, accompanied by subdued ETP velocity in the long run of 3.5x in 2030, resulting in market ETP value traded of $ 29,685 tn in 2030. Assuming a market share of 4% results in Flow’s ETP value traded of $ 1.4 tn. Further assuming depressed NTI margins of 2.2 bps and moderately growing fixed costs, results in net profits of € 61m in 2030, compared to 92m (in 2016), 40m (’17), 161m (’18), 53m (’19).
Under usual business conditions, I can hardly imagine scenario a to come true. This results, or worse, could only happen if some adverse regulations are introduced, the business model is seriously broken or some serious operational risk materializes (i.e. software errors, hedging strategy not working, etc.).
b. Accounting for another volatile period accompanied by higher trading activity (velocity 6.0x), elevated NTI margins (6 bps) and higher variable renumeration (35% of NTI) within the above conservative base scenario (a) in the year 2029 lifts the fair value estimate to € 1,092 m (+32%). Assuming severe market corrections with higher volatility, velocity, margins is very reasonable, I believe. Additional periods with severe market volatility provides even more upside.
c. Higher growth of ETP AuM could very well materialize, since more investors adopt ETF strategies, especially in Europe, where FT has a very high market share and should strongly profit from such a development. Institutional investors are adopting bond ETF products and retail investors are using easy to use robo advisors on their smartphones (such as Scalable). Assuming ETP AuMs to grow 12% annually results in AuM of € 15 tn in 2030 up from 5.6 in 2019 (9.3% CAGR). Higher adoption of buy-and-hold strategies could lead to lower velocity of 3.0x longer-term (vs 3.5x in a.), partially offset by slightly higher market share of Flow, based on EMEA AuM growing above average. This scenario results in a fair value of € 1,605 m (+95%).
d. A volatile 2029 within the higher growth scenario (c) leads to a much higher estimate of € 1.986 m (+141%). A higher discount rate (e) of 10% reduces the fair equity value estimate by -30% to € 1,482 m.
My wide range for fair value estimates depends on a few key inputs and long term market trends mentioned above and gets even wider if I change other key inputs such as the general level of velocity, NTI margin, and FT’s ETP share. On top, huge upside potential could exist, if FT achieves higher NTI margins (i.e. by gaining market share in Asia). Currently, Flow Traders is priced consistently with scenario c.
A fair value per share that I derive from scenario d comes in at € 43.55 based on a fair equity value of € 1,986 m over 46.5m share. A margin of safety of 40%* gives us a buy price of € 26.13, compared to a current price of € 34 (incl. entitlement to interim dividend of ~2 euros, ex-date is Aug. 18). I believe there is a good chance for additional upside, based on even more favorable outcomes for key inputs.
*) Quick side note: Flow Traders scored an initial overall quality of 65% in my work-in-progress questionnaire (read more here), calling for a discount to fair value estimate or margin of safety of 40%.
Analyzing the key drivers for Flow Traders net profits provided me with a solid understanding of its business model and the profit dependency of high market volatility. My scenario analysis provided a feeling for the potentially wide range of fair value estimates.
Believing that there is a good chance for tremendous upside potential and a favorable risk/reward proposition in the long term, I put the buy price at € 26.13, hoping to buy it during a downswing of market volatility, profits and price.
I hope you enjoyed this blog post. Please feel encouraged to discuss my assumptions and methods below or to give general feedback. I am always happy to get new followers! 🙂