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Reuters reported recently that E*Trade Financial (NASDAQ:ETFC) is in talks with at least five bidders for the sale of its market making unit, called G1 Execution Services.  The brokerage decided to hive off this unit almost a month ago after the Financial Industry Regulatory Authority (FINRA) initiated a review of its historical order routing practices. The regulatory body will check whether the trades routed from E*Trade to G1 Execution were executed at the best possible price or not. E*Trade has a duty to find the best price for its clients, and could be subjected to various penalties if it is found that it did not fulfill this obligation. (See E*Trade’s Order Routing Practices Come Under Scrutiny)
In this article we will try to estimate the value that G1 Execution Services could fetch on its sale. We will continue to incorporate the market making unit in our model until an official announcement of the sale is made. That is because it is not uncommon for companies to cancel the sale of a business after talking to potential buyers.
The Sale Is Likely Fetch Around $75-$225 million For The Company
E*Trade’s market making unit makes money in the form of principal transactions revenue. It generated around $103 million, $105 million and $93 million in the last three years respectively. The revenue growth of this unit has remained muted in the recent past, and the trend is likely to continue in the near future due to the unfavorable macroeconomic environment. The business brought in only $43 million in the first six months of this year, a decline of almost 5% year-on-year. We project the company’s principal transaction revenue to remain just under $90 million for 2013 and 2014. Further, the economics of this business are tightening and its margins currently vary in the 10%-20% range, according to the firm’s management. 
By using the above information and by assuming a terminal growth rate of 2%, we valued the business for different levels of profit margins and discount rates. The results are shown in the table below. We believe that the terminal growth rate of 2% is justified because the business operates in a mature and competitive industry, and is unlikely to grow any faster indefinitely.
|Revenue||$90 million||$90 million||$90 million|
|Cash Profit||$9 million||$13.5 million||$18 million|
|Terminal Growth Rate||2%||2%||2%|
At cost of capital = 14%
|$75 million||$112.5 million||$150 million|
At cost of capital = 12%
|$90 million||$135 million||$180 million|
At cost of capital = 10%
|$112.5 million||$168.7 million||$225 million|
According to our calculations the business could fetch anywhere between $75 million to $225 million depending on the unit’s profit margin and the buyer’s cost of capital. This range also compares well with the $173 million that E*Trade paid for the unit in 2001. At that time, the unit was doing slightly better and was expected to generate $100 million to $110 million in revenue over the next year. 
Where We Could Be Wrong
Our valuation assumes that G1 Execution will continue to receive the same level of order flow from E*Trade even after it is sold to another firm. The assumption may not be too far from reality because at least two of the unit’s five bidders already have well-established market making businesses. These two companies – namely, Citadel LLC and Virtu Financial – are most likely interested in E*Trade’s order flow rather than G1’s technology. Some news reports also suggest that E*Trade is likely to commit a certain amount of order flow to the unit’s buyer. 
However, there is a chance that the order flow routed from E*Trade to G1 may be lower in the future. E*Trade’s order routing practices are currently under scrutiny, and the brokerage could be forced to route more trades to other market makers if its algorithms are found to favor G1 Execution at the expense of its customers. According to the Wall Street Journal, the brokerage has already dramatically reduced its order flow to G1 Execution after the investigation started.  The valuation of G1 Execution Services is likely to be much lower than our estimates if this scenario plays out.Notes:
- Exclusive: Citadel, Virtu, Two Sigma, RGM bid for E*Trade unit – sources, Reuters, August 28, 2013 [↩]
- Q2 2013 Earnings Call Transcript, SeekingAlpha, July 24, 2013 [↩]
- E*Trade To Buy Market Maker, Restructure, Ecommerce Times, August 30, 2001 [↩]
- E*Trade Exploring Sale Of G1X Trading Unit, EuroInvestor, July 24, 2013 [↩]
- E*Trade Sends More Trades Outside Firm As Routing Is Scrutinized, WSJ, August 9, 2013 [↩]