Description

Euronext is a leading operator of securities and derivatives exchanges across continental Europe with over 1,300 issuers and a combined domestic market capitalization of over €3 trillion.    The Company also has approximately 700 exchange traded funds (“ETFs”) and over 200 open-end funds listed on its markets.

Despite its appreciation over the last year, Euronext remains an attractive investment opportunity to generate a 15-20% IRR with a margin of safety against permanent capital impairment.  While Euronext has delivered on (and in some cases exceeded) its operating targets, including margin expansion and revenue growth since its IPO, Euronext’s capital allocation opportunity has yet to be realized, and given its highly cash generative characteristics, should be a 2016 catalyst.   Additionally, Euronext remains cheap on both absolute and relative valuation metrics, and the company should continue to expand margins while benefitting from the launch of new products and secular tailwinds.  Finally, with its solid balance sheet, Euronext should benefit from renewed M&A in the space.

Company description and background

Euronext was originally formed between 2000 and 2002 by the consolidation of the Amsterdam, Paris, Brussels and Lisbon exchanges and the London International Financial Futures and Options Exchange (“LIFFE”). It listed in 2001 and remained public until it was acquired by the NYSE Group (“NYSE”) in 2007 to form NYSE Euronext, as part of NYSE’s goal of becoming the first global stock market functioning across time zones. In 2013, Intercontinental Exchange Inc. (NYSE: ICE) acquired NYSE Euronext, and ultimately retained the operations of LIFFE while spinning off Euronext as a stand-alone publicly-traded entity in June 2014.

Today, Euronext operates the incumbent and leading securities and derivatives exchanges in each of its four main markets (France, Netherlands, Belgium and Portugal), providing a range of services including security listings, cash and derivatives trading, post-trading services, market data aggregation, and market solutions.  The Company operates a unique pan-European model, running one platform across various geographies with a single order book.  Altogether, Euronext is the leading listing venue, cash trading venue and second largest derivative trading venue in continental Europe.  Euronext derives ~60% of its revenue from transaction-based services and is highly concentrated in cash equities, which make up ~78% of total trading revenue. As a result, the Company is levered to the economic cycle of the markets where it operates.

After the 2008 global financial crisis, the European economy continued to struggle, driving cash trading volumes ~80% lower from the 2007 peak through 2012. In addition, the MiFID regulatory framework, launched in 2007 to increase competition and lower prices, resulted in a proliferation of lightly-regulated electronic Multilateral Trading Facilities (MTFs) and growth in dark-venue volumes. This fundamentally changed the structure of European cash equity markets and led to price erosion and the loss of market share by incumbent exchanges. However, the cash equity market ultimately stabilized in four to five years ago, with each incumbent leader’s share settling at ~65% and trading prices flattening at historical lows where low-cost MTFs would be challenged to profitably undercut them. The only MTF to arguably have gained enough scale across markets to become viable is BATS Chi-X, with ~23.1% of European equities market share. The second largest with mid-single digit market share, Turquoise, is no longer independent as it was acquired in 2013 by London Stock Exchange Group.

The US market had a similar experience, but with a different outcome.  In the US, cash equity trading volumes stabilized in 2010 but at much more unfavorable terms for incumbent exchanges: NYSE and NASDAQ market shares flattened at ~20% each vs. ~65% for European exchanges. At the same time, trading off-exchange, in dark pools and internally at broker-dealers, has continued to grow to 37% of total volume compared to our estimate of ~11% in Europe. While the respective maturity of the markets might partially explain the differences between the US and Europe, we believe that they are mainly driven by structural factors. The US operates under Best Execution rules (“Bestex”) that require brokers to execute each trade in the exchange market that offers the most favorable terms. The SEC requires broker-dealers and markets to provide quarterly and monthly reports on order routing and execution quality respectively, though “best execution”, which, while usually narrowly interpreted as best price and lowest fees, can mean different things to different investors. In particular, institutional investors often prioritize other aspects of the trade which are harder to measure - confidentiality, risk management, compliance, oversight, liquidity charges – none of which are optimized by brokers or incentivized by the rules. Bestex effectively is a regulatory framework which favors retail investors and large broker-dealers over institutions, consistent with the US market participant mix. The result of the US’s structure is that market participants, particularly brokers, are connected to all exchange platforms to comply with Bestex regulation resulting in a highly competitive environment for exchanges.

Europe, which generally has fewer retail participants and more mid-sized brokers, utilizes a different and less proscriptive approach that is more consistent with its market participant mix.  Put simply, Europe’s directives do not require mid-sized brokers to connect to all exchanges. This in turn helps keep broker costs low and creates a true wholesale market.  Exchanges will compete amongst themselves but brokers will only connect to one or two venues at a time, almost always including one of the incumbents.

In fact, BATS Chi-X is the only independent MTF that has achieved scale by taking a surprisingly consistent ~25% market share slice off of each of the major individual markets in Europe and creating a combined high-volume cross-continental exchange but with less liquidity in each security compared to the incumbent exchanges. Europe’s regulatory framework naturally limits the number of competitors that can operate at scale and the upcoming regulatory wave (MiFID 2, to take effect from 2017-2025) does not point to any significant changes on this issue. The goal of MiFID in 2007 of increasing competition and lowering trading prices was nevertheless achieved and regulation is now moving in a different direction which we believe will ultimately be to the benefit of Euronext.

Investment Thesis

Euronext operates a high quality business protected by a structural moat that can perform strongly even in challenged market environments.  Moreover, we believe Euronext’s new stand-alone structure and incentivized management team will allow the Company to continue to improve its efficiency and capture adjacent sources of revenue.

1)       High quality business characterized by a network effect and high returns on capital:  Euronext operates the incumbent regulated exchanges in each of its four main markets with a ~65% stabilized average cash trading market share on listed securities, reflecting a monopolistic position and substantial barriers to entry. Euronext benefits from the network effect of its dominant position which translates into superior market quality, depth and liquidity, resulting in lower trading costs for its clients, who are incentivized to continue trading on Euronext. In fact, we do not believe that market volumes can support another market entrant to operate profitably at scale other than those currently operating, given the higher-quality service of Euronext coupled with industry-wide rock-bottom pricing.  As part of NYSE and during the trough of the European macroeconomic environments in 2012 and 2013, Euronext still achieved ~41% Adj. EBITDA margins. As a standalone company, Euronext has been able to achieve Adj. EBITDA margins in line and above the industry average of 45% to 50%, in fact ENX is expected to finish 2015 at 53% Adj. EBITDA margin. 

2)       Regulatory and political barriers to entry:  Euronext has built strong longstanding ties to regulators in the countries where it operates, as it continues to set the bar for transparency, security and stability as the reference exchange in each market. This enables the Company to monopolize certain exchange services such as market open /close auctions, listings, secondary and follow-on offerings. Further European regulations geared towards increasing transparency, reducing systemic risk and reappraising capital usage should only help Euronext stave off potential new entrants and capture additional market share, while political intervention has historically favored incumbent exchanges which are frequently viewed as strategic national assets.

3)       Strong management team with track record of successful execution:  Buried inside NYSE, Euronext’s businesses were split across different global divisions where they did not represent a meaningful part of overall revenues, while being burdened with numerous “parent company” costs and processes.  Euronext’s management team announced and successfully executed a cost cutting plan that will achieve €80m in annual savings by 2016, an increase over the original plan of €60m and one year ahead of time. Recently, Euronext appointed Stéphane Boujnah as the new CEO, filling the seat that had been vacant since May after the departure of Dominique Cerutti.  Mr. Boujnah was formerly the Head of Continental Europe at Santander Global Banking and Markets, and will be joining the company this month.  While Mr. Boujnah has not articulated his own plan or strategy in a detailed fashion, we believe that the company will continue to focus on cost initiatives.

4)       Renewed focus on innovation and revenue growth:  The Company has continuously announced initiatives and products to reinvigorate businesses that were underexploited under NYSE, which reflects management’s focus and opportunity.  Euronext has also successfully executed on its innovative revenue-sharing agreement with LCH Clearnet to clear all of the Company’s derivatives. Such an arrangement will continue to allow ENX to continue benefitting from effectively having access to its own clearing operation without incurring either the direct cost or the risk that comes with ownership.

5)       Favorable cyclical and trading tailwinds:  European total cash value hit its lowest level in 2012 since the Federation of European Securities Exchanges (FESE) started publishing data in 2000. In 2014 and YTD 2015 cash volumes have seen a substantial rebound of +17.6% and +31.1%, respectively, but levels remain depressed at approximately 60% below 2007 peak levels and 40% below average levels. On the derivatives side, over the past few years muted volatility has dominated the market, also driving European volumes to depressed levels, though market activity has increased recently. 

6)       Value creation through capital allocation:  Exchanges, including Euronext, are generally high free cash flow (FCF) generation businesses primarily due to high margins and low capital needs. Euronext, which generated approximately €100m of FCF in 2014 had net cash of €42m at the end of Q3 2015. While it currently pays out dividends representing 50% of net income, Euronext’s prolific cash flow generation (we expect over €150m in 2015) and strong balance sheet should merit a more favorable return of capital to shareholders in the form of a special dividend or an increase in the payout ratio. Peers run other exchanges business with 1.0x – 1.5x net leverage. If ENX were to transition its balance sheet in line with peers, the Company could pay its comfortably pay its shareholders a special dividend of approximately €7/sh. or 15%+ return on its current stock price.

Though the Company should continue to thrive as a stand-alone entity, it could also be an attractive acquisition target for other European exchanges seeking to gain greater scale and leverage the exchange’s predominantly fixed cost structure. Euronext’s Universal Trading Platform (UTP), which enables the integration of exchanges across markets and the cross-listing of securities, could also make a potential acquisition more attractive as it would provide the basis for further integration.

At a current price of approximately €44/sh., the Company is valued at approximately 10.6x EV/ (2016 EBITDA-CapEx) and a ~7.0% free cash flow yield on 2016 excluding net cash.  This valuation compares favorably to that of an average of peer European exchanges that trade at ~12x 2016 EBITDA – CapEx despite the fact that Euronext is still in the midst of its margin expansion and new product launch initiatives.  Longer-term, we believe that the Company can achieve its stated goal of 5% organic annual revenue growth and exceed its current 50%+ EBITDA margins, leading to free cash flow approaching €3.50/sh. per share by 2018.  Such a scenario, including a return of capital to shareholders as mentioned above, would lead to a valuation more in line with its peers, and should result in the value of the stock reaching €65 per share in the next two to three years.  We also believe it is possible that Euronext can accrete additional value by participating in M&A or in the space or by being acquired by a strategic buyer.

Catalyst

Capital allocation

M&A