Wednesday, April 25, 2007

The Publicly Held Exchange Industry -- Any Value Left?

The publicly owned exchange industry is comprised of the firms that own and operate the world's major and minor stock and commodity exchanges. The exchange industry is a relatively "new" industry, in the sense that almost all of the publicly owned exchanges went public -- that is, demutualized (meaning to transition to a for-profit corporation from not for profit) -- from 2000 onward.

Most of the largest exchanges are now, as of 2007, publicly owned including the NYSE Group, NASDAQ, the Hong Kong Exchanges Group, the Chicago Mercantile Exchange and London Stock Exchange, for example. Notable exceptions are the AMEX (which plans to demutualize in 2007), all Indian and Mainland Chinese exchanges, all Japanese exchanges, and all Latin American (exchanges except those with ties to BME).

All publicly held exchanges are valued as of 4/07 as follows:

Ticker; Company; Enterprise Value $US; P/E – trailing/projected; Earnings Increase(Y/Y); Stock Apprec (Last 2 Years); Trading Volume Annual Increases(04-06)
NYX; NYSE Euronext; $12.56Bn; 62.8x/24.7x; +402%; 203%; Approx 10%
NDAQ; Nasdaq; $3.0Bn; 43.8x/19.3x; +106%; -10%; Approx 10%
LON:LSE; London Stock Exchange; $5.1Bn; 36.3x/na; +80%; 200%; 33% (06 only)
CME; Chicago Merc Exchange; $19.53Bn; 45.2x/28.7x; +32%; 113%; 31%(06 and 3 mo 07)
BOT; CBOT Holdings; $9.63Bn; 52.3x/33.1x; 125%; 97%; 19%
NMX; NYMEX Holdings; $11.1Bn; 66.9x/34x; 118%; -5% (IPO 11/06); 40%
TSE:X; TSX Group (Toronto); $3.0Bn; 25x/na; 27%; 150%; 27% (06 and 3 mo 07)
SAfrica: JSE; Johannesburg; $891M; 42.0x/na; +107% (EBT);1,685%(public on 4/05); 25% (but -20% in 2003)
S:S68; Singapore Stock Exchange; $4.9Bn 25.2x/na; +72%; 250%(public on 12/00); Flat to Slightly Negative 04-06
HK:388; Hong Kong Exchanges; $10.8Bn; 33.7x/na; +88%; 71% (LTM); 72% in 2006
ESP:BME; BME(Spain); $4.34Bn; 55x/na; +36%; 33% (LTM); 50% in 2006
SWE:OMX; OMX(Nordic Countries); $3.1Bn; 23x/na; +68%; +70%(LTM);20%
ASX:ASX Australian Stock Exchange; $4.05Bn; 35.4x/na; +32%; +130%; 40%(2006)
NOR:OSLO; Oslo Bors; $550M; 13.5x/na; +70%; +70%; 50%
NZ:NZX; New Zealand Stock Exchange; $169M; 35.6x/na; +31%; +475% since IPO in 04; Flat volume in 07

Valuations of the Exchange Industry:

Based on a comparison of the stocks in the industry, certain facts and trends are evident. First, there are few bargains in the exchange universe, with current P/E's (at 4.24.07) of 30x or more, up to 60x, due mainly to very high stock appreciation across the board in the industry. Most of the appreciation has occurred in only the past two years and, in certain cases, only in 2007. For example, OMX Group which represents the stock exchanges for the Nordic Countries -- Stockholm, Copenhagen, Finland, Island, and the Baltic Countries -- has appreciated approximately 70% this year and mainly in March and April 07, from relatively flat performance in 2005 and 2006. Stock performance has been extremely positive even challenging commodity based stocks in total return since 2004.

The high appreciation has led to quite high valuations for certain exchanges, if to compare with valuations in other industries. For example, CME -- Chicago Mercantile Exchange -- is valued at approximately 20% more than Cameco in terms of market capitalization -- $19.5Bn vs $16.5Bn. Cameco is the world's largest miner of Uranium, providing 20% of the world's supply of Uranium, while CME is one of three US based commodity exchanges, albeit the largest, and one of several international commodity exchanges -- so faces significant competition. The comparison in terms of value from an "eyeball test" appears to favor Cameco vs CME. Additionally, major commodity exchanges are planned to open in the Middle East and Russia -- translating to potentially more competition going forward in the commodity exchange industry.

Trading Volume is The Key Driver of Income

Second, it becomes clear that the number one driver of earnings for stock based exchanges are fees on trading volume. Exchanges earn income in three main areas -- 1. transaction fees: a small fee per transaction, typically well less than 1 cent per share, but dependent on the exchange, 2. Listing fees, based on a flat fee year per company and new fees per company IPO's, and 3. Information services, outsourcing their trading technology to other exchanges and partners.

Surveying the publicly held exchange firms, fees on trading volume for almost all of the exchanges is the largest profit center, and also is the fastest growing profit center across firms in the exchange industry. For example, the Olso Stock Exchange -- a quite small regional exchange by international standards (but still with a current market capitalization of $550M!) -- earned 62.7% of total 2006 operating income in equity trading fees, and 28% from information services. For Olso, equity trading fees were up 45% in 2006 and 49% in 2005 year over year, while information services also grew at a good clip, 33% in 2006 but only 7% in 2005.

Numbers of listed firms has been relatively flat across most of the stock exchanges, with the single exception (of the firms listed above) of the London Stock Exchange, which has seen approximately a 10% annual increase in numbers of firms listed since 2002. Part of this reason may be Sarbanes Oxley in the United States, which has made cost and compliance burdensome for public firms. Nevertheless, trading fees have been a much higher driver of profits for London than exchange fees.

Note also it is possible for the exchanges to come up with new products that could potentially be popular with investors and lead to higher fees, based on revenues from these products, such as interest rate derivatives, new index funds, etc. However, in the introduciton of these products, the exchanges will compete with the major brokerages for market share.

For Some Exchanges, Higher Fees Are the Main Driver of Trading Volume Revenues

Trading volume revenues can increase either from 1) higher trading volume or 2) higher fees per share traded. For Nasdaq and NYSE Group, the volumes traded have not increased by more than 10% over the last 3 years, but income has increased well in excess of 30%. This is mainly due to higher fees, although fee information is difficult to find in the exchanges' 10-k's. Investors should be cognizant that there are already grumblings in the major brokerages that the fees are becoming too high. Citigroup, for example, has instituted a group to investigate a separate system to trade shares that does not depend on the major exchanges' systems, to combat high fees (see:

In addition, the investor should also be wary of steep rises in trading volume in international markets. For example, the Australian stock exchange has experienced trading volume increases of 50% in 2006. Perhaps this is due to increased activity by funds and hedge funds internationally. But, in comparison, the New Zealand Stock Exchange (NZX), with a somewhat similar economy and demographic situation, has seen flat to slightly declining trading volumes in 2007. The NZX's CEO's conclusion regarding flat to lower trading volume is that trading volumes will always be cyclical and this is good advice for the investor -- to be mindful of the cycle of the exchange and economy in terms of trading volume -- but on the positive side as countries experience economic growth generally over time trading volume will increase.

Does Value Exist in the Exchange Industry?

The London Stock Exchange, NASDAQ and Oslo mainly stand out as potentially undervalued. Olso is on this list due to the relatively low p/e ratio of 13x -- but the exchange appears overvalued on first glace due to its market value of $US550M, serving as the main exchange for a country of only 4 million people. NASDAQ, interestingly, owns 28.8% of the London Stock Exchange, acquired in a failed takeover attempt and this action may have made both firms relatively undervalued in comparison to the rest of the industry.

The London Stock Exchange Appears The Most Undervalued

London has very strong volume growth that appears more sustainable than other smaller international exchanges, as it is the major regional center and is well positioned against the US exchanges as the key world financial center. Europe as a whole is showing surprisingly strong economic growth, coming off a low growth base with economic reforms instituted. The CEO has publicly stated that the current market capitalization of $5.1Bn is undervalued (and therefore will not accept the $5.1Bn bid from NASDAQ, although it is possible that prestige issues may also be present in the decision not to sell to the relatively upstart NASDAQ). London's p/e is reasonable in comparison with the industry at approximately 36x 2006 earnings. The only concern is the possibility that NASDAQ will dump its approximately 30% stake causing a significant decline. Mitigating this possibility is that NASDAQ hopefully (probably) will see that London remains a good investment -- and evidence here is that NASDAQ of course attempted to buy London.

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