Description

Bolsas Y Mercados Espanoles (BME)

BME operates the Spanish stock exchange. The company derives more than half of its revenue from the most commoditized, lowest growth and most competitive segment of the industry, namely European cash equities trading.

The introduction of MiFid (European Markets in Financial Instruments Directive) in 2007 opened European cash equities trading to competition from multilateral trading facilities (MTFs). MTFs are basically alternative trading venues which compete with the primary exchanges for trading volume in all the major European stocks. The launch of MTFs marked the end of the cash equity trading monopolies. Within a short period of time, Europe’s new trading venues captured significant market share away from the primary exchanges and industry pricing started coming under pressure.  Initially, the most immediate casualty was the London Stock Exchange. After capturing 10% share of trading volume in FTSE100 stocks, the MTFs gathered significant steam. LSE’s market share of trading volume in its own listed companies, declined from 90% to less than 60% in just 18 months. In order to avoid further deterioration the LSE eventually reduced its all-in trading prices by >50% and the market shares eventually stabilised around the 50%-60% levels. The same subsequently happened to the other European primary exchanges including Xetra and Euronext.

This deterioration in business quality, from monopoly status to commoditized businesses with relatively low barriers to entry, combined with the lack of growth in European cash equity volumes also caused investors to lower the earnings multiples awarded to cash equity trading houses. Whilst in the past, these businesses traded at similar multiples to other parts of the market infrastructure industry, investors now value them at P/E ratios in the 12x-14x range compared to post-trade and index businesses selling for >20x forward earnings estimates.

There was one major exception to all this, namely BME. While all its European peers were suffering heavy market share losses and price compression, BME managed to maintain close to 100% share and its pricing continued to increase.

In 2014, the all in average cost of equity trading on BME was 1.55bps, compared to 0.92, 0.74 and 0.64bps at Euronext, Xetra and LSE respectively. The average cost of a trade on BATS is just 0.15bps.

As short sellers scrambled to cover their positions and European cash equity trading volumes began to show some cyclical improvements in the 2^nd half of 2013, BME’ shares rallied heavily from the c.€20 level at which the shares had been stuck for nearly 5 years  to >€30. Then, in the 1^st half of this year, benefitting from the excitement around the potential impact that European QE may have on trading volumes, the shares rose further, exceeding €40 in April. In the context of this year’s consensus earnings per share expectations of €2.1, the shares reached a peak of valuation multiple c.20x P/E, on par with the levels at which it traded before the 2007 introduction of MiFiD and a premium to the likes of Deutsche Boerse and LSE.

Interestingly, the timing of this huge rerating of BME could not be more misguided. The company’s ability to fend off the MTFs and avoid the fate of its European peers is about to take a significant turn for the worse. The reason that MTFs have been unsuccessful in Spain is that there are some unique regulations around Spanish equities trading that act as a deterrent against trading away from the primary exchange. However, due to the need to comply with certain new European regulations, the country is in the process of implementing significant financial market reforms. Some of these reforms are already in place while others are going into effect on October 9^th of this year. The effect of the reforms already in place is clearly visible as BME’s market share of IBEX35 trading volume has already fallen to below 80% by the end of last year and has continued to deteriorate so far this year.

However there remain some post trade complexities that create higher operational risk when trading on MTFs vs trading on the primary exchange which we highlight below:

• MTF trades settle over 2 cycles instead of 1: In laymen terms, while a trade on the primary exchange gets settled with the stock and cash exchanging hands at the same time, a trade at an MTF settles in 2 cycles. First the stock changes hands and then (perhaps an hour later) the cash changes hands. This causes extra operational risk.
• In Spain, the central custodian registers all counterparties and beneficial ownership in any trade. MTFs currently have to supply this info 3-4 hours earlier than BME. This increases the likelihood of a trade break because there is less time to satisfy the reporting requirements.
• Trades in Spain currently settle on T+3. If the beneficial ownership data is missing, BME offers the possibility of settling the trade the following day (i.e. T+4). However, if the trade was executed on an MTF a new T+3 cycle is required (i.e. it becomes T+6).

On October 9^th those differences will be eliminated and MTFs will finally be able to compete on equal footing with BME. By then we expect BME’s market share losses to accelerate and its pricing to begin falling precipitously.

It is worthwhile noting that the effect on BME from MTF competition could end up being more severe than what other exchanges experienced because of the heavy concentration of Spanish trading volume. The key barrier to market share gains for an MTF is to build sufficient trading liquidity in a particular stock so that bid/ask spreads would be narrow enough. A wide bid/ask spread offsets any benefit a trader has from the lower price charged by the MTF. The extent to which the primary exchange has narrower spreads than the MTF dictates that extent to which it can charge higher prices. At BME, 3 stocks (Banco Santander, BBVA and Telefonica) account for nearly half of the total volume on the exchange. The top 6 stocks account for c.60% of total volume. This means that MTFs should be able to easily achieve narrow spreads in those key names which in turn will force BME to reduce prices further than simply getting to par with the other European exchanges. In addition, BME’s market share could decline further as well.

On top of the competitive issues discussed, there is new European regulation called Target2Securities (T2S) under which the settlement of cash equities in Europe is going to be outsourced to the ECB. When Spain joins T2S (scheduled for early 2017) BME will lose another €30m in revenue which given the fixed cost nature of the business will drop straight the bottom line, representing another 15% earnings headwind.

Finally, there are 2 more regulatory headwinds facing BME:

1. Open Access: new European regulations will allow market participants to choose where to clear any equities trade.  Analysts currently expect BME’s newly launched clearing house to contribute positively to earnings, but once open access comes into force they may lose most of this revenue as clients choose to clear at a larger clearing house where they can optimise collateral efficiency
2. Financial Transaction Tax: Though the EU wide tax on equity transactions has so far been postponed several times, if/when it eventually does come into force, it will act as another headwind to BME’s earnings power

Putting it all together we see significant downside to BME shares over the next 12-18 months. Even if we assume equity volumes continue their current cyclical recovery and BME’s market share and pricing does not decline further than what we saw at other European exchanges, we derive an earnings per share forecast of €1.5 for 2017. Applying an appropriate 13x multiple to this we get a stock price below €20, which is nearly half the current price.

On the flip-side, we perceive limited upside risk in the shares. Fundamentally, the shares are pricing in a scenario that is frankly unrealistic because the shares are currently priced for growth while we believe a best case scenario for this business would be flat earnings. The key risk would be some kind of takeover as the market infrastructure sector is still consolidating. That said, we view this as only a remote possibility for a number of reasons. Buying BME at a premium would cost at least $4 billion so that only the larger exchange groups could even consider it and it so happens that none of these groups are currently interested in acquiring a European cash equities business. The best proof of that was the recent IPO of Euronext. ICE was desperately looking for a buyer, but there was none. Given that Euronext represented a far more interesting acquisition target because of its higher cost base (i.e. more synergy potential for the acquirer) and the fact that its earnings are already post the competitive onslaught form MTFs and yet there was no buyer, we believe that it is highly unlikely that a buyer will suddenly emerge for BME. In addition, BME’s high valuation makes a deal even less likely because there are far superior assets around trading on similar multiples.

Catalyst

Accelrating market share declines

Deterioration in pricing

Cosnsensus dwongrades to adjust for adverse regulatory developments