|Shares Out. (in M):||276||P/E||0.0x||0.0x|
|Market Cap (in $M):||8,540||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||1,863||EBIT||0||0|
Over the past 3 years LSE’s management has transformed the group from a mostly commoditized, cyclically driven business to a highly attractive, structurally growing business with pricing power and high barriers to entry. Through a series of acquisitions, including MilleniumIT, FTSE, LCH.Clearnet and Russell (to close later this year), the business mix has shifted from being more than 50% geared to equity capital markets activity towards close to 80% of profits being generated from mission critical market infrastructure and indices.
The investment thesis for LSE is based on the 3 following assessments:
All of the factors above have started to play out and we believe we are approximately halfway through the process.
While equity capital markets businesses tend to sell for c.12x forward earnings, derivatives and post trade infrastructure companies trade for 18x-20x earnings and the only listed pure-play index business - namely MSCI Inc. - trades on 20x forward earnings. The S&P index franchise is owned by publicly traded McGraw-Hill Financial, which is also on 20x forward earnings. The reasons for this valuation difference lie in the growth profiles and competitive natures of the respective business models. While equity capital markets business are relatively mature and growth is mainly driven by cyclical changes in trading volumes, LCH’s clearing business is growing rapidly due to regulatory changes forcing over-the-counter (OTC) transactions in derivatives to be cleared by registered and regulated clearing houses. LSE’s index businesses are benefitting from the structural growth in ETFs and benchmarking driving annual revenue growth at FTSE of 22% per annum for the past decade. Unlike cash equity trading exchanges which face significant competition from alternative trading venues, LCH and FTSE operate with very limited competition due to the high barriers to entry in these businesses. We believe that investors will eventually award the LSE with a similar multiple, representing a 60% increase from the company’s historical average multiple of c.12x. So far, using consensus forecasts, the multiple has already increased to c.15x, consistent with our view that we are nearly halfway through this opportunity.
When the LSE completed the acquisition of LCH.Clearnet last year, management guided for €23 million in annualised cost savings as of the 3rd year post closing of the transaction. This represented 7.7% of LCH’s total cost base at the time. There are a number of reasons why it was clear that this number would be increased significantly. Firstly, mergers in the market infrastructure space are not a new phenomenon. More than a decade of merger data shows that these types of deals have consistently yielded cost synergies of 25-30% of the target’s cost base. Performing in line with past mergers in the sector alone would already allow for more than tripling of the announced cost savings. In addition, LCH was previously run for the benefit of its member banks who mutually owned it rather than for the maximisation of profits. This has resulted in an extremely inefficient cost structure. To illustrate this we can compare LCH to Deutsche Boerse’s clearing house, Eurex Clearing, whose operations are only slightly smaller than LCH’s. In 2012, Eurex Clearing employed 105 people, costing c. £8.5 million or 10% of its total cost base of £86 million. LCH’s total cost base for 2012 was £249 million, 47% of which was due to the cost of its 767 employees. In 2013, this cost base rose further as its number of full time employees grew to c.900. On top of all that, LCH outsources its IT systems through 12 different IT contracts and c.500 consultants. Given LSE’s strong in-house technology capabilities, particularly at MilleniumIT, the Group should be able to cut costs significantly from phasing out these outsourced IT contracts and consultants. Our base case estimates conservatively assume the LSE achieves €100 million in cost savings at LCH by 2017. Four times the initially announced number. Here things are also moving on track. In May, LSE’s management announced that they have increased the cost savings target at LCH to €60 million, all of which should be achieved in 2015. The CEO’s words regarding the new cost savings target in relation to future cost savings opportunities were: “think of it as a down payment”.
Finally, in addition to the annual 5%-7% price increases across the index business (which is what MSCI implements), there are 2 major pricing opportunities at LCH.Clearnet. As mentioned, prior to being acquired by LSE, LCH was run as a utility for its members/owners rather than as an independent profit driven organisation. This is evident in its pricing structure. For example, LCH’s SwapClear subsidiary charges just $0.3 per $1 million of notional value for clearing of OTC interest rate swaps in the US. Its only local competitor, CME, charges a headline price of $5-$6. In addition, until this year, SwapClear was subject to a profit share agreement with its member banks wherein most of the upside streams back to the banks. The restructuring of this agreement will unlock considerable value for LSE shareholders as SwapClear is the key beneficiary of new regulations making the clearing of OTC interest rate swaps mandatory. As with the 2 other pillars of the investment thesis discussed above, here we have also seen good progress. Firstly, LSE has increased the membership fee for LCH’s large members by 50% and secondly, the profit share agreement has been restructured so that a least 60% of SwapClear’s profits now remain with the company.
Why the opportunity still exists
As mentioned earlier, LSE is in the process of completing the acquisition of the Russell index business. As part of this deal they also acquired Russell’s investment management business (it was a package deal). Management has made it abundantly clear that they don’t currently see any reason to hold on to the IM business (although this is subject to strategic review – which we believe is code language for “we’ll let you know when we find a buyer”). They are financing the Russell deal in part with equity which will be issued in September. In addition to market environment of recent weeks, the overhang of an upcoming $1.6bn equity raise has temporarily halted the re-rating process over the past 4-5 months.
Putting all of the above together, we see LSE earnings at least 175p in EPS by 2017. Putting this on 18x forward P/E equates to a 2 year IRR of >30%. If they maintain their target leverage of 1.5x-2x and use the excess leverage capacity to repurchase shares/make additional accretive deals this EPS number could exceed 230p. In addition, as discussed, LCH synergies could eaily be larger than our base case. Finally, we haven’t at all mentioned the interest income opportunity as interest rate increases still seem far off, but needless to say this represents considerable further upside here.
The downside seems fairly limited (outside of general market de-rating etc) because all of the drivers mentioned are either self-help or structural drivers (driven by regulations).