The Changing Face of Nasdaq OMX
Acquisitions are helping the exchange operator tap other revenue sources.
In the evolving world of financial exchanges, Nasdaq OMX Group (NDAQ) is zigging and zagging to remain vibrant. We believe the company is right to develop alternative revenue streams, which have widened via acquisitions. But given the changes, we think investors would benefit from an exploration of our view of the large exchange operator's strategy and performance to better understand the potential upside to the shares. And while significant challenges remain, in an improved operating environment and with proper execution, we think Nasdaq could be worth up to 21% above our current fair value estimate.
The company has gone through its share of recent turbulence, as major systems problems sullied its image twice in the last two years, drawing regulatory scrutiny and possibly imperiling future business. Meanwhile, the competition is bulking up, as two exchange deals are in the works that will fuse some of Nasdaq's staunchest rivals into larger companies that may be in stronger positions--closely held BATS Global Markets and Direct Edge are merging whereas NYSE Euronext was acquired by IntercontinentalExchange (ICE). But Nasdaq isn't standing still. Under CEO Robert Greifeld, Nasdaq is busy integrating two acquisitions of its own--a suite of corporate-services businesses acquired from Thomson Reuters (TRI), and the eSpeed U.S. Treasury trading platform from BGC Partners (BGCP)--that are injecting valuable additional diversity into the company's operations.
We expect the fight for market share in equities and derivatives trading to remain fierce. Nevertheless, we believe Nasdaq is becoming a more diversified enterprise, with potential to deliver improved earnings in the years ahead. Its stock is trading close to our updated fair value estimate of $39 per share, but could be worth as much as $47 under the right conditions.
Nasdaq's Revenue Mix Is Changing
Today's Nasdaq is a far cry from the market upstart that in 1971 launched trading with 2,500 over-the-counter securities. Known as the National Association of Securities Dealers Automated Quotations, the company was an offshoot from the NASD, the brokerage industry regulator that now is part of the Financial Industry Regulatory Authority, or FINRA. Nasdaq rose to become a star in the U.S. capital-markets firmament, along the way helping pioneer the initial public offering business, hosting technology titans such as Apple (AAPL), Intel (INTC), and Microsoft (MSFT), paving the way toward electronic stock trading--and becoming a thorn in the side of the once-unassailable New York Stock Exchange. Eventually, Nasdaq separated from the NASD and became a public company, part of a trend that saw other once-private financial exchanges around the world list their own shares in the open market.
Nasdaq now has significant operations overseas, in good part thanks to its 2008 trans-Atlantic merger with OMX AB. The deal diversified Nasdaq's revenue, and the international business portfolio now includes exchanges in Armenia, Denmark, Estonia, Finland, Iceland, Latvia, Lithuania, and Sweden. It also operates markets for power derivatives and carbon. But the bulk of the company's gross revenue--about 78% in 2012--still originates in the United States, where Nasdaq runs three equities markets (including the original Nasdaq), three options markets (including the former Philadelphia Stock Exchange, established in 1790), and a futures marketplace. Owning multiple marketplaces helps Nasdaq segment its customer base.
In 2014, we estimate that about 27% of Nasdaq's estimated $2.1 billion in net revenue will come from the transactions side of the company's Market Services segment--the largest of Nasdaq's four operating groups-- compared with about 30% in 2012 before the recent acquisition spree. When analyzing Nasdaq's top-line performance we typically focus on net revenue, which subtracts the cost of revenue, such as transaction rebates and brokerage, clearance, and exchange fees. The Market Services segment draws two income streams. The larger is fed by transaction and clearing fees in products such as equities, derivatives, and fixed-income securities, and the other is supplied by revenue from access and broker fees. We estimate that this smaller subsegment will account for about 13% of 2014 net revenue.
We project that the Technology Solutions segment will supply 26% of Nasdaq's net revenue in 2014. That is up from 17% in 2012, as the importance of this business segment is growing because of the acquisition of the Thomson Reuters corporate-solutions businesses. In this transaction Nasdaq acquired a set of investor-relations, public-relations, and multimedia businesses. These businesses complement existing Nasdaq operations in corporate services. The services span offerings such as investor-relations advisory, web communications, press-release services, media-monitoring tools, and on-demand video. When the deal was announced, the Thomson Reuters businesses generated about $233 million in annual revenue, well ahead of Nasdaq's $97 million from its own efforts in the space. Here, Nasdaq competes with other IR and PR providers (Ipreo is a large rival) in a battle to service corporate customers large and small, including Nasdaq-listed and nonlisted companies. While there are competitors, we believe the business will generate recurring revenue, as it's based largely on subscription models. We also see these businesses as having some stickiness with customers due to small to moderate switching costs. However, at this point we do not view this as strong enough to have an impact on our view of Nasdaq's overall moat rating or moat trend.
The third segment, Information Services, will provide about 23% of projected 2014 net revenue, in our view. In Information Services, Nasdaq sells market-data products to market participants and also licenses indexes such as the Nasdaq 100. Rivals include other index groups, such as S&P Dow Jones Indices. The acquisition of eSpeed also added another market-data revenue source to this segment.
We think the fourth business segment, Listing Services, will provide the remaining 11% of estimated 2014 net revenue. In our view, this business will continue to reap the benefits of limited competition in the U.S. market, which provides most of the segment's revenue. We believe most large companies contemplating a U.S public listing seriously look only at Nasdaq and the New York Stock Exchange. We expect that duopoly to hold in the near term, though Nasdaq could face a stiffer fight against the NYSE to convince issuers that its marketplace is sound after recent technology problems.
The eSpeed acquisition supplies Nasdaq with a well-known electronic platform for the trading of U.S. Treasury securities. The system, whose competitors include ICAP's BrokerTec, generated $78 million in 2012 revenue (about an estimated $75 million on a net revenue basis). As discussed earlier, the deal brings with it a dose of market data and other revenue as well, which amounted to an additional $21 million in revenue. We believe that the eSpeed deal will benefit Nasdaq as U.S. Treasury trading picks up.
In our view, there is upside to transaction volumes in on-the-run U.S. Treasuries, assuming that the American economy continues to gradually improve, which would pave the way for the end of the Federal Reserve's quantitative easing efforts. In the first nine months of 2013, U.S. Treasury trading activity, as tracked by the Securities Industry and Financial Markets Association, or SIFMA, is up about 6% year over year. Our initial assumption is that eSpeed's transaction net revenue grows at a compound annual rate of about 6% during 2013–17. Part of the eSpeed revenue stream is contracted out at more-fixed rates, which may limit the near-term upside, but we believe that over time these contracts will be adjusted as they come due.
In our view, Nasdaq's acquisitions of the corporate-solutions businesses and eSpeed will help diversify the company's revenue stream further away from equities trading. Although the new revenue mix will not dramatically alter transaction-based revenue's contribution to the top line, the inclusion of eSpeed's fixed-income revenue will reduce the significance of equities trading, to about 9% of overall net revenue in 2014 from about 12% in 2012.
We do not view the transactions as risk-free, as the aggregate price was not cheap. For a combined cash price tag of about $1.1 billion, Nasdaq is getting businesses with more than $300 million in annual revenue. Additionally, there is a yearly stock payout that we expect will be offset by expected tax benefits of around $33 million annually during the next 15 years. To pay for the acquisitions, Nasdaq had to issue an additional EUR 600 million (about $811 million) in debt and also tapped its revolving credit line for $50 million. In the short term, the added leverage heightens Nasdaq's financial risk and limits the company's ability to buy back stock, which we believe would be a positive if the company did so at prices below our fair value estimate. Over the near to medium term, we expect the debt load will move toward a more manageable 2.5 times EBITDA, compared with a projected more than 3 times in 2013.
We think Nasdaq's narrow economic moat benefits from cost advantages and network effects. We also think intangible assets, in the form of Nasdaq's brand, help nontrading businesses such as listings. Scale allows the company to deploy the costs of additional trades over its trading platform, allowing a greater portion of incremental transaction fees to flow to the bottom line. Network effects also play a role, as traditionally the liquidity of a deep trading pool should help attract other market participants. However, the marketplace has been steadily losing market share, as off-exchange trading platforms and newer exchanges have gained strength. A combination of regulatory changes and improving technology has helped make the equities landscape more competitive, allowing other networks to take root. Even a determined small trading platform with access to good technology can, over time, build a following. Additionally, if a new trading platform has the backing of Wall Street firms, it can jump the initial hurdle of forming a trading liquidity pool. Moreover, the fungible nature of equities (as opposed to more-exclusive futures, which we regard as endowed with greater moat attributes) commoditizes stock trading, in our opinion. Systems increasingly focus on metrics such as speed of trading, an attribute that we view as difficult to build a moat on.
Indeed, Nasdaq's market share in the trading of U.S. equities has dropped to around 18% in the third quarter of 2013 from nearly 30% in 2008. Nasdaq also has lost ground in the trading of its own listed stocks. Although the market-share situation has been somewhat more stable over the last year, we do not expect this situation to improve materially in the near term. We believe that Nasdaq will continue to wage a tough battle for market share and do not believe it will move significantly closer to its earlier share of market-volume highs absent some type of structural change. For instance, this could take the form of securities reforms that make it less desirable to take trading volume into dark pools of liquidity. But the path to reform is fraught with uncertainty. Changes can take prolonged periods to take root and may not produce the intended results. In the meantime, high levels of competition persist in equities and options trading. Accordingly, we view Nasdaq's moat as stuck on a negative trend, as its network effects and scale advantages weaken.
The trading business operated by eSpeed, meanwhile, should have moat attributes similar to those of Nasdaq's existing trading operations: cost advantages and network effects. The fixed flat fee pricing, instead of completely variable by volume pricing, of part of the eSpeed revenue stream limits the advantages to scale, though over time we believe Nasdaq will alter the structure of these arrangements to provide more upside as volumes increase.
Technology Problems Pose Risks, but Not Crippling Ones
We believe that Nasdaq's recent run of technology problems presents a risk to the company, but not one that will be crippling. The well-chronicled glitches include the mishandling of Facebook's (FB) initial public offering in May 2012, followed 15 months later by a trading outage in Nasdaq-listed stocks. We agree that part of the problem has been the growing complexity of the U.S. equities market, which has made it more challenging to monitor possible points of failure and expands the junctures where things can go wrong. But investors would be wise to keep in mind the broader context here, which is that Nasdaq is hardly the only market to have received a black eye recently. CBOE Holdings (CBOE) was hurt by a trading outage in April, and shortly before the Facebook fiasco another rival exchange company, BATS Global Markets, was embarrassed when systems problems led to the scuttling of its own IPO. Thus, we think some of the fallout is broadly shared across the industry, leading to regulatory pressure for exchanges to be more vigilant.
However, this is now two consecutive years that investors have been disrupted by significant Nasdaq-related problems. We think it may be a stretch to expect regulators and the investing public to have much more patience should a major third malfunction erupt in the near future. If so, regulators could take more drastic steps, such as mandating tough technology standards or punishing exchanges more aggressively for failures. As far as investors, it is true that alternatives for moving trading elsewhere are limited in a world where technology problems are commonplace. However, we do not underestimate the psychological toll that a steady drumbeat of negative publicity about market failures could take on smaller investors, who may grow distrustful of the system.
As far as the fallout from the recent problems, we think it will be limited. We do not think that Nasdaq will be forced to dramatically escalate its capital expenditures, which last year came to 5% of net revenue and 13% of operating income. However, we think it would be reasonable to expect some turbulence in the image-driven competition for company listings. But even there we do not anticipate a long-lasting material blow to Nasdaq's ability to court, win, and retain big-ticket company listings. That is because we view the dynamics of the listings business in the United States as unlikely to change dramatically anytime soon. In the U.S., we continue to view this as essentially a two-company competition between Nasdaq and NYSE Euronext. While the recent stumbles should prompt due-diligence questions from company executives contemplating a Nasdaq listing, we think the marketplace will continue to notch its share of victories. Listing Services revenue makes up about 11% of Nasdaq's overall net revenue base. We think this is a relatively sticky business, as most companies tend to stay put once they choose an exchange. The sticky nature of listings is encouraging, as we think it has spillover image benefits for Nasdaq's other businesses.
News of a planned merger that will unite rival market operators BATS Global Markets and Direct Edge led us to contemplate the likelihood that a third viable competitor for big-ticket U.S. listings would emerge. In short, we think this is certainly possible over a longer time span but unlikely to develop quickly. It doesn't make sense to us that the folks who shape decisions in company listings--such as CEOs, CFOs, corporate directors, and influential investors--would rush to embrace a new and unproven entrant. We believe that image and branding are important considerations in listing decisions and we think Nasdaq retains an edge here over new rivals, even taking into account the recent problems. While listing fees are surely a consideration, we suspect that most large companies are usually weighing other factors more heavily, such as listing alongside peer companies, branding benefits, quality of trading, and other services that an exchange can offer.
M&A Opportunities and Stewardship
We think Nasdaq still carries allure in the exchange mergers-and-acquisition game. Nasdaq's stock is trading well off its highs from earlier years, and we think it is possible that the shares will continue to invite takeover speculation. Like other exchange stocks, Nasdaq has come down sharply from its peak as trading volume has been unsatisfying. It is possible that buyers, such as other exchange groups, could see value in making an acquisition play for Nasdaq. InterncontinentalExchange's move to buy NYSE Euronext set loose takeover chatter around the exchange sector, though nearly a year after that deal was unveiled it is noticeable that no other similarly large exchange transactions have surfaced (one limited exception is the BATS-Direct Edge combination). We think that the arguments in favor of consolidation among exchanges remain intact, such as joining complementary product sets (part of the strategy behind the IntercontinentalExchange-NYSE deal) and reaping efficiency gains from the combination of trading technology. The latter has been part of Nasdaq's playbook in the past, as the company moved acquisitions and new ventures to a common trading platform, which allowed for a more efficient marketplace. We do not see Nasdaq as desperate to sell, and if no appealing options develop, then we think the company will remain independent and continue to make targeted acquisitions.
We still consider Nasdaq's stewardship of shareholder capital as Standard. Under CEO Robert Greifeld, Nasdaq has been able to produce solid returns on capital (adjusted for factors such as goodwill), and we expect this to continue. We view this ability of the ongoing business to produce solid returns as evidence of Nasdaq's narrow moat, weakened though it may be. Management's record is not free of blemishes, as we believe it is fair to assign it blame for the recent technology problems. Furthermore, we have concerns that Nasdaq may have overpaid for some of its acquisitions. Nasdaq's goodwill balance (more than $6 billion, or about half of all assets) recently exceeded the public market capitalization of Nasdaq stock. Also, the 2012 goodwill impairment testing was a little too close for our comfort, though no impairment was found. Moreover, management has been unable to turn back the tide in the loss of Nasdaq-listed market share, though market-structure issues play a role there because earlier market reforms have helped Nasdaq's rivals gain volume.
Gaston F. Ceron does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.