Knight shares look like a ‘buy’

For opportunistic investors, it isn’t too early to focus on the silver lining of the $440 million trading-glitch-related loss at Knight Capital Group Inc. (KCG).

Certainly, it has been a painful early August for existing shareholders of the electronic-trading and market-making firm.

Although the emergency $400 million rescue deal essentially will triple the number of outstanding shares of Knight Capital Group stock, the market appears to be cooperating in presenting a potential opportunity for new shareholders.

The stock price has declined by 70% since the Aug. 1 software malfunction that triggered the loss.

The stock closed Friday at $2.90, and analysts who have scrambled to revalue the stock are starting to see a ray of hope.

At S&P Capital IQ, equity analyst Ken Leon has set a price target for the stock of $3.50, which is down dramatically from $13 prior to the loss but still about 17% above where the stock is trading.

Factoring in the $440 million third-quarter loss, which Knight Capital Group chief executive Thomas Joyce reportedly has estimated will be trimmed to $270 million after taxes, Mr. Leon expects Knight to lose $1.55 a share in the third quarter but still earn 7 cents a share in the fourth quarter.

For the full year, he now expects Knight Capital Group to post a loss of $1.80 a share and earn 40 cents a share in 2013.

Prior to the trading loss, Mr. Leon had reported earnings-per-share estimates of 95 cents this year and $1.50 for 2013.

The wild cards surrounding the stock at this point involve when and how the members of the new investment group will convert the 267 million newly created shares of convertible preferred stock, as well as market and investor reaction to Knight Capital Group under the new ownership.

CONFIDENCE QUESTION

“Knight will be profitable,” Mr. Leon said. “But we still don’t know what kind of confidence there will be in the company.”

Steven Wallman, founder of custody and brokerage firm Folio Investing, said that the oversize trading loss hasn’t altered his confidence in Knight Capital Group, nor will it change their counterparty relationship.

“We have found Knight to be a terrific organization all the way through,” he said. “In my view, this loss is not a reflection of them, although there is clearly something that went awry.”

For some perspective on the $440 million loss, consider that Knight Capital Group is a company that typically generates about $50 million a month from market-making activity.

Anyone holding shares of Knight Capital Group stock prior to the trading glitch suffered a “75% haircut,” in the words of Mr. Leon.

However, it was certainly a bountiful deal for the six-member investment group that pooled resources to rescue Knight Capital Group: Blackstone Group LP, Getco LLC, Jefferies Group Inc., Stephens Inc., Stifel Financial Corp., and TD Ameritrade Holding Corp.

“Everyone’s cost in Knight was $1.50 a share, and that’s an unrealized gain that they already have,” Mr. Leon said, meaning that the newly issued convertible preferred shares of the company created to compensate the rescue team are already worth about $3 a share.

It isn’t yet clear, however, when those shares can be converted and sold, and Knight Capital Group spokeswoman Kara Fitzsimmons wasn’t able to provide specific details.

Regardless, several analysts, including Mr. Leon, already have revalued Knight Capital Group assuming full dilution of the 267 million new shares of stock, giving it a post-rescue fully diluted book value of about $4 a share.

“The deal Knight made [with the investment group] was a necessarily quick response, and when you’re in that tight of a corner, you will accept some very strict terms,” said Michael Wong, an equity analyst at Morningstar Inc.

“We’re talking about a trading loss that occurred over a period of about 45 minutes,” he said. “Losing $440 million that fast is practically unimaginable.”

Mr. Leon echoed a similar sentiment that such is life on Wall Street.

“This is what happens when there’s a blowup. The community of Wall Street comes together and helps out, and also makes some money along the way,” Mr. Leon said.

“Knight Capital had to make a decision in 24 hours, plus the weekend, and if management didn’t do what they did, we would be talking about a bankruptcy,” he said.

[email protected] Twitter: @jeff_benjamin