Thursday, December 27, 2007

TSX Group -- An Undervalued Takeover Candidate

TSX Group, the stock exchanges group of Canada, is the 7th largest stock exchanges group in the world by market capitalization of listed firms. TSX Group is attractively priced, with positive operating prospects, and therefore represents an attractive acquisition candidate. The exchange industry is rapidly consolidating, driven by the competitive advantage of larger exchanges vis-a-vis smaller exchanges in terms of capital raising for listed firms. Further, exchanges exhibit high operating leverage, and therefore mergers make sense from a financial and competitive standpoint. These factors make TSX Group a compelling long term buy at the the time of the writing of this article (early 1/08)

TSX Group Overview:

TSX Group holds the major stock exchanges of Canada, including the Toronto Stock Exchange, the Vancouver Venture Exchange, NGX, the main Canadian natural gas exchange, and, with the merger announced at 12/07, the Montreal Exchange. TSX Group holds strong positions in listed mining and oil and gas firms, as TSX is the largest exchange for mining as defined as the combined market capitalization of listed firms, and ranks #1 of all stock exchanges in terms of the total number of listed oil and gas firms.

TSX Group accrues income mainly from trading fees, listing fees and market data fees -- trading revenues has been the largest segment by revenue, representing 41% of TSX's 9 months 2007 revenue, while Listing fees (or "Issuer Services") comprised 32% of revenues and market data fees contributed 27% of the group's 9 months 2007 revenue. Note that TSX does not break out margins by operating segment, so trading appears to be the group's most significant segment in terms of profitability. All three of TSX Group's operating divisions grown at a high rate over from 2002 to 2006, with a compounded annual growth rate (CAGR) of revenues of 17%, and an EPS CAGR of 34%.

1: TSX Group Historical Financial Performance from 2000 - 2006

In $C 1,000’s








Total Revenue








% Increase








Net Income








Net Margin








The Trading segment has demonstrated the fastest growth of TSX's three operating segments, growing at a CAGR from 2002 to 2006 of 21%, verses a CAGR of 19% for Issuer Services and 12% for the Market Data segments over the same period.

Trading volumes have increased due to a combination of increased trading by funds -- possibly (probably) hedge funds -- and day trading by smaller investors -- both of which, in turn, have been driven by the expansion, of the overall TSX index. TSX has instituted price cuts in its trading -- mainly in an effort (in the author's opinion) to enhance competitiveness vis-a-vis a proposed alternative trading system (ATS) backed by the major Canadian Banks (note that the risk of an ATS to TSX Group will be discussed in further detail below). However, the large rise in trading volumes, from an average of approximately 100 million shares traded per day in 2001 to an average of approximately 380 million per day at the end of the 3Q 07, has more than offset pricing declines.


Going forward, trading volumes will be a major driver of income for TSX Group, which will be driven by fund activity. It is possible that TSX Group may stabilize its pricing for trades, depending on its competitive position to the proposed ATS system -- this issue is dependent to a degree on the success of its new trading technology and resistance of customers to trade on alternative systems. (again this issue will be explored in more detail below).

In the Issuer Services segment, revenues have been driven by the growth in the market capitalization of existing issuers and a number of new (mainly resource based) Canadian firms that have gone public and/or raised additional capital over the past five years. Issuer services fees are based on new listings and a fee based on the market capitalization of the listed firms. The Canadian economy and stock and commodity markets, have done well, this segment has benefited. The market data segment has been driven by increased numbers of subscribers -- mainly financial firms and funds -- to its real time market data services, from under 100,000 in 2002 to 155,000 in 2007.

Valuation Comparison of TSX Group to Other Exchanges:

A chart of the P/E's and growth rates of many of the worldwide exchanges is included in my other article on the Public Exchange Industry, which can be found here. The data in that article is not too dated at the time of the writing of this article, and, in summary, currently, the P/E ratio of TSX is very reasonable at 23.6x, compared to 37.5x for NYSE Euronext, 60.7x for the NYMEX and approximately 100x for the Hong Kong Exchanges Group. NYSE Euronext's earnings are forecasted to increase at a CAGR of approximately 23.6%, and NYMEX's earnings are forecasted to increase at a CAGR of 40.8%, both according to Yahoo finance. Note that author has not been able to find earnings projections for the TSX Group or the Hong Kong Stock Exchange, but as noted above, 5 year historical EPS CAGR for TSX is 34%.

Valuation Comparison of TSX Group to ASX Limited:

Comparisons of Valuation with ASX Limited (Australian Stock Exchange) appears to be most appropriate on a comparable basis, due to the fact that Canada and Australia have similar economic structures (commodity and financial institution based economies), political systems and demographic situations. As shown in the chart below, ASX sells at a significant premium to TSX Group, as ASX is valued at approximately $US9.45Bn, while TSX Group is valued at approximately $US3.5Bn. The Canadian GDP is approximately $1.18 Trillion, compared to the Australian GDP of $675Bn (according to the CIA World Factbook), while Canada has a population of approximately 33.4 million people compared to Australia's 20.4 million. Based on these metrics, the discount of TSX Group compared to ASX Limited appears unjustified.

in $US

Market Cap



Firms on Exchange Capitalization*

Average Daily Volume**


TSX Group







ASX Limited







* Firms on exchange capitalization is defined as the sum of the market capitalizations of the equities listed on the exchange.
** Average daily volume is defined as the number of equity shares only traded per day -- for TSX Group, this measure only includes the Toronto Stock Exchange
Note that Australian dollars and Canadian dollars are translated at an exchange rate of $Aus/$US of 0.90 and $C/$US of 1.00.

Valuation of TSX Group Compared to Recent Exchange Acquisitions:

Recent Merger activity within the Exchange Industry has priced acquisition targets at levels above TSX Group's current market valuation on a price to earnings basis, implying a premium purchase price to current levels if there is a takeover attempt of TSX. In Chart 2 below, valuations for the recent mergers of OMX (by NASDAQ), the Italian Borse (by the London Stock Exchange), the Montreal Exchange (by TSX Group) and the Takeover of the Philadelphia Stock Exchange by NASDAQ.

3: Valuations of Recent Acquisitions in the Exchange Industry:

Acquired Firm


Acquisition Price (in $US)*

Price/Earnings (Historical)








Announced 5/07

Italian Borse





Announced 6/07






Announced 11/07


TSX Group




Announced 12/07

TSX Group Comparison

Market Capitalization**

Price/Earnings (Historical)


TSX Group




* Acquisition price, when priced in stock, is adjusted for the market value of the stock at early 1/08.
** Market Capitalization and other ratios of TSX Group do not include the Montreal Exchange.

The average p/e ratio of the 4 acquired firms above (price to earnings ratio defined as the purchase price divided by the historical earnings of the acquired exchange) is 33.8x, which is 43% above the current p/e ratio of the TSX Group (pre-merger with the Montreal Exchange). The price to revenues of the acquired exchanges is lower than TSX Group in 3 of the 4 acquisitions listed above, but note the price to earnings basis is the more appropriate measure to value exchanges, due to differing cost structures between firms -- TSX Group's margins are increasing with higher revenues, due to operating leverage.

Rationale for Acquisitions in the Exchange Industry:

A good discussion of the flurry of merger and acquisition activity in the exchange industry can be found at Knowledge@Wharton. Exchanges are combining to take advantage of economies of scale -- trading technology can be applied to acquired exchanges, lowering overall operating costs, which translates to higher margins with higher revenues. Further, from a competitive standpoint, larger exchanges offer more choice to financial customers, as customers can trade across a larger, more diverse set of investment options, and, with mergers of exchanges located in different countries, across international boarders. Larger exchanges also offer potential listed firms a larger venue in which to raise capital, and higher liquidity for their shares, with tighter bid and ask prices. Additionally, larger exchanges pose stronger competitive advantages vis-a-vis brokerages and investment banks, which have complained that exchange industry fees are getting too high -- so potentially are exploring other trading options for shares and other financial instruments -- alternative trading systems -- that do not rely on the exchange to bring buyers and sellers together. With an large, established exchange, it is more difficult to "circumvent" this exchange verses a smaller, regional exchange.

TSX Group 9 Months ended 9/30/07 Update:

TSX Group posted EPS increases of 22.7% to $C1.73 per share for the first 9 months of 07 compared to the 9 mo 06, on revenue increases of 19.7% to $C313.5M. Net margin increased slightly to 37.7% the first 9 months of 07 from 36.8% for the equivalent period in 06. As shown in the table below, the increase in net income was driven mainly by listing fee increases, and, to a lessor extent, by trading and market data revenue increases.

4: TSX Group 9 Months 2007 Operating Performance:

9 Months Ended 9/30/07

9 Months Ended 9/30/06

% Increase

Trading Segment Revenues:




Trading Segment Volume: (# shares)*




Issuer Services Segment Revenues:




Listed Companies (Number)*




Listed Companies (Total Market Cap)*




Market Data Revenues:




Market Real Time Data Subscribers:




* Trading Segment volume and market data includes the Toronto Stock Exchange and the TSX Venture Exchanges, but not Energy Markets (NGX), Shorcan Brokers (Fixed Income Trading). Note also that the newly acquired Montreal Exchange is not included in the 9 months 07 numbers above.


- The largest threat to TSX Group are alternative trading systems (or ATS's) to potentially circumvent Toronto Stock Exchange Trading earlier this year (in 5/07). An announcement concerning ATS developments in Canada sent TSX's market capitalization down 12.5%, details of which can be found in here. Canada may have as many as 8 separate electronic trading systems by the end of 2008 (details here). Note that the ATS that the banks have proposed is initially meant for large block trades -- which makes up less than 10% of the volume of TSX's trades currently -- and is similar to the 30 or so "dark pools" (ATSs) that exist in the United States, which trade mainly large blocks of securities between funds. ATS's could potentially climb to taking pieces of normal trading volumes in both countries with advances in technology and more willingness to place electronic trades.

Partially mitigating this risk of trading volumes going to ATS's is the fact that TSX has recently (in 12.07) launched what is one of the most technologically advanced trading platforms in the world -- named TSX Quantum -- which can complete trades in under 10 milliseconds (TSX's previous technology could complete trades in only several 100's of milliseconds). Details of the TSX Quantum launch can be found here. TSX Quantum is comparable to NYSE Euronext's new service which will be launched in 2008 with processing times of 10 milliseconds Note that NYSE Euronext is generally thought of by financial professionals to be the leader in terms of trading technology, so the favorable comparison with the NYSE is impressive for TSX Group. According to the CEO of the TSX Group, generally the exchange with the faster processing times will win the trade, all other factors equal. Further, faster technology for processing trades allows volumes to go higher without corresponding cost increases.

According to
Jackie Chung, president of Competitive Metrics Inc in Canada (which recently completed a report on ATS's in Canada), it is likely that the launch of ATS's in Canada will result in a somewhat smaller piece of a larger trading pie, but Chung also notes that TSX Group will be a fierce competitor with the new "dark pools." However, it is not exactly clear to what extent the ATS's will impact trading volumes at TSX Group, so investors are encouraged to watch developments concerning ATS's closely going forward.

Susceptible, But Resistant to a Market Downturn:

It is believed by some exchange industry participants that the exchange industry "will make money if the market goes up or down." In the recent book "Rigged" by Ben Mezrich published in 2007, the Executive Vice President of Strategy for the MERC expressed this viewpoint -- due to the fact that trading volumes can stay the same or perhaps even rise in a declining market. But the recent history of the TSX shows that a rising market is better for the exchange's profitability, and, as demonstrated in chart 1 above, TSX Group suffered a drop in revenues of 17% and a decline in net margin to 16.8% from 35.3% from 2001 to 2002, mainly due to the market downturn in these periods. Earnings did not decline to negative territory as would have been expected in an industry such as machine tools, but revenues and margins were significantly negatively affected, and therefore the recent history of the TSX shows that a rising market is better for the exchange's profitability.

Partially mitigating recession risk is the diversification of TSX Group, which operates in both commodity-based (mainly through the trading of mining and oil and gas equities, but also through TSX's natural gas exchange, NGX) and equity trading. Diversification was a different issue during the last downturn (2002) due to the fact that commodities were not valued then as highly as they are currently. Certain analysts -- recently the chief economist at BHP has expressed this opinion -- have projected that if there is a slowdown in the US, China and other emerging markets will not be dramatically affected, and commodity prices will continue to stay relatively strong, which would benefit TSX Group.


TSX Group is attractively priced and is a good acquisition candidate in the exchange industry, which is undergoing significant consolidation. As such, TSX Group represents a compelling medium to long term buy. The largest risk to TSX Group is the proposed Alternative Trading Systems for potential launch in 2008, although this risk is partially mitigated by the fact that most of the systems are designed for mainly large block trades, and the fact that TSX Group has much more advanced (faster and more reliable) trading technology for the completion of trades. Further risks include the risk of recession in the US that chokes off Asian growth and negatively affects the Canadian economy. Interested TSX Group investors are encouraged to closely watch developments with regards to Alternative Trading Systems and the global economy closely going forward.

Tuesday, December 11, 2007

Petrobras' Tupi Discovery Will Likely be Profitable

Petrobras announced the Tupi discovery in the Santos Oil Basin of between 5-8Bn barrels at 11.07, which appears to be recoverable numbers of oil and natural gas equivalent, as opposed to total resource numbers (of which recoverable oil is a fraction). The Tupi oil find generated significant enthusiasm both inside and outside of Brazil -- to the extent that the Brazilian President Luiz da Silva declared in a speech concerning the oil find that "God is Brazilian." Not only is the 5-8Bn barrels very large in itself, but, according to Petrobras CEO Gabrielli, Tupi is just a "tiny'' part of the total Santos Basin reserves.

The main questions that come to mind for the interested investor are: first, how much daily production can be expected from Tupi? And when will production come online? Further -- related to the first two questions -- how expensive will the Tupi field be to produce? And, further, what are the technical challenges to production? Overall, these questions can be grouped into an overall question: How profitable will Tupi be for Petrobras? This article will explore these questions, to the extent that the information has been made public as of the date of the writing of this article (12.07). Note that the author is not a petroleum geologist, so it is possible that mistakes will be found herein regarding technical issues -- the author has attempted to cite every assertion concerning technology issues with regards to the Tupi Oil Field.

Overall Significance of the Tupi Discovery to Petrobras:

As a perspective on the Tupi oil discovery, the latest oil production forecast for Brazil at 6.07 was presented by British Petroleum at 7/07 in the chart below. Note that this forecast most likely did not assume the successful production of Tupi specifically but rather some (most likely smaller) production success in the Santos Basin, as Tupi was not announced at 6.07 (and the Santos Basin was previously expected to produce mainly natural gas). From the forecast, one can summarize, Petrobras has several projects in the Campos Basin -- Tupi is located to the south in the Santos Basin -- which are expected to increase production regardless of how Tupi performs, in BP's estimate from approximately 2.0M bpd in 2007 to 4.0M bpd in 2020. Nevertheless, it is a significant positive if Tupi moves forward, from both a production and reserve standpoint -- Petrobras' 2P reserves were approximately 12 bn barrels and the Tupi discovery may move Petrobras' 2P reserves to between 17Bn to 20 Bn barrels (an amount significantly larger than Exxon Mobil's reported 1P reserves of 13.3Bn barrels at year end 2006). But in summary, Tupi is important, but not critical to the overall oil and natural gas production success of Petrobras.

Projected Future Oil Production of Brazil (pre-Tupi discovery):

Source: Historic, BP Statistical Review of World Energy, June 2007;
Forecast, BMI Research

How much oil will Tupi Produce?

Petrobras announced on 11/12/07 that Tupi production will go over 200,000 bpd in 10-15 years, with a pilot production of 100,000 bpd in 2011-2012. In terms of how much production can go over 200,000 bpd, the head of Petrobras exploration and production, Hugo Repsold, has indicated that 1M barrels per day of production is achievable, as a peak production figure.

The question of how much will be produced is related to questions concerning how the field will be produced from technological standpoint. If this field was a typical offshore oil discovery then the production numbers would likely offer little doubt as to their eventual achievability. But the main issue concerning Tupi is an unusually large and deep salt layer deep under the ocean floor, which covers the oil reservoir. A graphical depiction of this salt layer and the overall depth of the Tupi resource has been provide d by the excellent oil website The Oil Drum:

The salt layer combined with the large depths -- the Tupi oil discovery is 4 to 5 miles below the ocean floor -- make certain technologies necessary for the production of the field. The salt layer needs to be understood and effectively drilled through -- with a resulting stable wellbore -- requiring new technology and expertise to effectively manage through the salt layer. Salt at this depth is reported to act like sludge, with some unknown physical properties, meaning that construction of an effective wellbore may be difficult. Petrobras is assessed to have the technology to produce currently, as they have already drilled a number of test wells into the Tupi resource to make their size estimate public -- therefore the main question is cost. The field is likely to be expensive, which will be explored in the next section.

How Expensive will the Tupi Field be to Produce?

The respected consulting firm Wood MacKenzie has estimated that the total field will cost between $50 and $100Bn to produce, all in. Importantly, the cost range does not indicate the final production numbers from the field, so this makes a feasibility calculation (through a payback period, difficult to do (but a range under certain assumptions will be done in a section below, to shed light on Tupi). This amount comes in on top of Petrobras's planned $118Bn in spending announced for the next 5 years for all other projects, including refining, gas and ethanol pipelines, and other oil fields besides Tupi. These numbers indicate that Tupi will be expensive, but not prohibitively so for a firm of the size of Petrobras. But note that cost estimates for Tupi exhibit significant ranges. One Brazilian petroleum geologist has stated that costs for Tupi would be 10x higher than for oil fields produced in the Campos Basin, to the north, where the majority of Petrobras' current production exists. This would result in costs of over $100M per well. However, cost estimates have exhibited a very wide range, from $30M per well (according the the Petrobras CEO) to $250M per well -- the cost per well of the exploratory well. Full production of Tupi -- again Petrobras has not disclosed if this means 200,000 bpd or 1,000,000 bpd (which is a critical piece of information that is lacking currently) -- would require approximately 100 wells. Cost estimates for 100 wells in the Tupi field would then range from $3Bn at $30M per well to $25Bn at $250M per well.

Note that well costs tend to decline with more wells due to expertise and also the fact that some of the costs can be amortized over time -- the first well requires workers to be moved out to the location while more wells mean that labor and equipment are in place and ready to work translating to low transition costs. Therefore it is unlikely there won't be some cost abatement from the first test wells of $250M per well.

Further, there is a need for more Floating, Offloading and Storage Facilities (FOPF) -- which are offshore rigs but based on floating tankers instead of attached to the ground in order to produce the Tupi discovery. The costs of these FOPF's are in addition to the cost of drilling the wells. Petrobras' CEO Gabrielli has estimated that between 6 and 12 FPSO's will be needed to produce Tupi -- but did not indicate what amount of oil each FOPF would produce (in other words, how much production would 6 FOPF's produce verses 12 FOPF's?). There are only 70 FOPF's worldwide according to wikipedia at 2006, so likely shipbuilding facilities will be run overtime to provide several for the production of Tupi. -- with the bill of course going to Petrobras.

Estimate of Payback Period under Certain Assumptions:

Assuming an all in start up cost of between $50Bn and $100Bn - the Wood MacKenzie's estimate stated above - would mean a very wide ranging payback period of between 2 and 35 years, depending on the assumptions for production, oil price, and lifting costs. Note that lifting costs in the North Sea are estimated at under $15 per barrel of oil -- $20 is utilized for the cases below.

Scenario 1: Base Case:
500,000 bpd of total final production, oil price of $70, lifting costs of $20, total start up costs of $80Bn: Payback period: 7.3 years

Scenario 2: Low Case:
200,000 bpd of total final production, oil price of $60, lifting costs of $20, total start up costs of $100Bn: Payback period: 34.5 years

Scenario 3: High Case:
1,000,000 bpd of final production, oil price of $90, lifting costs of $20, total start up costs of $50Bn: Payback period: 2 years

*Note that in all cases, the time period in which capital expenditures are accrued but production has not come online is not included -- for example, if Petrobras takes two years to get to the point where some production is started up, these two years are not included in the payback period. Further, production numbers are assumed to be average numbers over the production period -- when in reality the field will rise to a "peak" then decline. Lastly Oil price is assumed to be constant over the payback period.

Clearly, the scenarios above present a very wide range, ranging from essentially uneconomic in the "Low Case Scenario" to massively profitable on the "High Case Scenario." The most likely case in the author's opinion -- named the base case above -- shows a 7.3 year payback period, which is at the upper limit for a payback period for a typical oil and gas project, as most oil firms would like to see a payback period of under 5 years, to reduce uncertainty and leave capital for other projects. However, for projects with a longer reserve life (larger reserves with more expected years of production), oil firms will likely be more willing to fund a longer payback period project. At 500,000 barrels per day of production, the Tupi oil field is expected to have a reserve life of between 27 and 47 years (at 5Bn and 8Bn barrels of reserves, respectively), which certainly fits the criteria for a long life asset, as, for example, most oil firms operating in the Gulf of Mexico have overall reserve lives of under 15 years.

The long life of the Tupi oil field is similar to oil sands projects, which have reserve lives of over 40 years. Oil sands firms are willing to fund projects with somewhat longer payback periods because of the long producing life -- the 5 year typical payback period is for conventional oil projects. For example, Suncor spent for the 4 year period through 2001, $3.4Bn in capital expenditures to double the capacity at its Millennium Project, which added an additional, approximate 130,000 barrels per day of production. In 2001, the oil price was significantly lower than it is today in late 2007, so it is likely Suncor was only budgeting between $10 and $15 per barrel in profit after the project was completed. These profit assumptions translate to a payback period of between 4.8 and 7.1 years (at $10 to $15 per barrel of profit) for Suncor's Millennium expansion.

As such, with long lived reserves but high initial capital expenditures, Tupi can be viewed similarly to a heavy oil project -- meaning that an expected pay back period of moderately over 5 years is acceptable and likely to be funded profitably.

In terms of the most likely cost and production scenario, the author would lean towards higher start up costs (closer towards the $100Bn estimate), but also a higher oil price going forward, and also somewhat higher than 200,000 barrels per day final production, with more than 6 FOPF's with 100 wells operating in the area. This scenario is reflected as mentioned in the "Base Case" above.

In summary, a cost estimate, roughly, shows that Tupi should be moderately profitable going forward, with risks of a lower realized oil price, cost overruns and lower realized production. These risks are partially offset by Petrobras' expertise in operating in deepwater -- Petrobras is the world's leader in offshore technology, and continued expected pressure on the oil price due to growth in Asian countries and lower expected production from conventional sources. Note that also there is significant upside to the profitability of Petrobras if the oil field is larger than initially reported.

Possible Benefits to Petrobras From Technological Expertise in Developing the Tupi Oil Field:

On the bright side, the technological expertise required to successfully extract the Tupi oil field will likely result in technology that allows for an enhanced ability to drill below deep salt layers, which will likely result in an increased ability to extract deep sea hydrocarbons in many other offshore areas with similar characteristics, such as West Africa and other South America. Further, preliminarily, Petrobras appears to be able to benefit from pioneering this deep sea salt drilling technology due to the ability to license and consult for other offshore projects with similar characteristics.


The Tupi oil find is quite promising, from a profitability standpoint, under most reasonable assumptions of oil price, cost and production figures. The expected profitability of Tupi is obviously quite positive for Petrobras investors. Further, Petrobras investors may see increased reserves and production from the Santos Basin beyond the initial 5-8 billion reserve estimate, which would boost profitability estimates. However, significant risks exist if oil prices drop going forward and/or the field proves to be too technologically challenging to develop, due to the unprecedentedly deep and thick salt layer. These risks are partially mitigated by Petrobras' expertise in deep water, and positive prospects for the price of oil. However, investors are encouraged to watch developments and news concerning the Tupi oil field closely over the next several years to determine if the technological risks are sufficiently mitigated.