Description

Investment Thesis

I am recommending London Stock Exchange Group (“LSEG”) as a long. LSEG is in the final stages of a business transformation from a transactional exchange operator to a recurring data and info services company, which has yet to be fully reflected in the company’s valuation. Given this business transition, LSEG is an underappreciated beneficiary of several “super trends” in finance including shift to passive/index investing, rise of quant and data science driven investing, democratization of data via AI and the migration of fixed income trading to electronic   In addition to becoming a more predictable business, LSEG’s growth algorithm has structurally improved as well, resulting in expected EPS growth in the low-teens over the medium term. Coupled with a potential re-rating to more accurately reflect higher quality business mix, we believe LSEG can generate a 20% IRR in the coming years.

Business Overview

To simplify the business, it’s best to think about LSEG as operating in two end markets - financial data/information/analytics and financial market infrastructure - across five reportable business segments: Data & Analytics, FTSE Russell and Risk Intelligence (collectively the “data businesses”, which comprise ~2/3rds of EBITDA) and Capital Markets and Post Trade (the “financial infrastructure” businesses, which comprise ~1/3rd of EBITDA).

LSEG’s “data businesses” are asset-light, recurring businesses with high barriers to entry. The company’s “financial infrastructure businesses” are transactional in nature but possess naturally arising duopoly/monopoly characteristics and are benefitting from secular growth in fixed income electronic trading and regulatory-driven derivatives clearing mandates. LSEG is an asset light, high ROCI business with consolidated EBITDA margins of nearly 50%. A brief sketch of the company’s key franchises within these two groups is provided below.

“Data Businesses” 

Data & Analytics comprises two main businesses, Workflows and Feeds.

• The Workflows (23% of total sales / 16% of total EBITDA) business provides desktop/mobile terminals which supply data, news and analytics to financial professionals under the “Eikon” (legacy product) and “Workspace” (next gen product) brands. Eikon/Workspace is the #2 terminal provider behind Bloomberg with low 20’s % market share. Eikon/Workspace tends to be used by bank trading desks and sell-side departments with less presence in traditional asset management. Eikon has historically been a share donor and priced at a discount due to product underinvestment and service issues; operational improvements and Workspace’s lighter and more intuitive UI has stabilized the business with LSD % growth and low 90’s % gross retention and the potential to improve further.

• The Feeds business (23% of total sales / 20% of total EBITDA) is the leading provider of enterprise data (pricing, volume, corporate actions, terms and conditions, etc.) to financial institutions and asset managers, with >50% market share. LSEG amasses data from 550 venues in 190 countries covering 80m securities and distributes it to thousands of customers, across a variety of frequencies (low latency to end-of-day). This data is used to run and is deeply integrated into critical internal trading and risk management applications within these institutions, resulting in extremely high switching costs. With relationships spanning decades, the business also benefits from first mover advantage as there is a community of engineers that are familiar with programming with the LSEG symbology/taxonomy. The Feeds business operates with 3-5 year contracts and has a high 90’s % gross retention rate.

FTSE Russell (11% of total sales / 15% of total EBITDA) designs and sells financial indices used for performance benchmarking by asset managers or to underpin financial products such as ETFs or derivatives. 70% of revenue is generated by recurring subscription fees (deliverables include index constituent, weight, corporate action and other information) and 30% is from asset-based fees. The index industry is an oligopoly comprised of MSCI, S&P Global and FTSE Russell, each of which specializes in unique geographic and asset-class niches. Barriers to entry are considerable as underlying customers rely upon the brand value/trust (objective methodology, calculation reliability, name recognition, etc.) that these index providers confer to manage and sell financial products. Further, switching costs are formidable as they require funds to change their benchmark which draws scrutiny from investors, can require approval from asset owners (pensions) and have onerous regulatory implications (refiling of fund prospectus, remeasuring of historical track record, etc.), resulting in mid to high 90’s % gross retention and attractive pricing power.

“Financial Infrastructure Businesses”

 This collection of businesses is comprised of two primary assets: Tradeweb (within Capital Markets) and LCH (within Post Trade).

LSEG’s 51% stake in publicly listed Tradeweb comprises the bulk of the Capital Markets segment, (7.5% of total revenue, 11% of total EBITDA). Tradeweb operates an online marketplace for trading, amongst other things, sovereign and corporate credit. Corporate credit trading is in the middle innings of being “electronified” (corporate credit remains largely traded through voice or IB today; electronic has 35% share across investment grade and high yield combined), resulting in what we believe to be a sustainable 10%+ top line, mid-teens EPS growth algorithm for market leading Tradeweb over the medium term. Given its growth profile and leading market position (effectively a duopoly with MarketAxess in electronic fixed income trading), Tradeweb unsurprisingly attracts a premium valuation with a current P/E of 41x. Tradeweb’s mark-to-market value represents approximately 20% of LSEG’s market cap and is akin to a hidden asset.

The remaining assets in this division are the London Stock Exchange equity listing/trading business and a small FX trading platform. It’s worth emphasizing that LSEG’s namesake asset – the London Stock Exchange – is now financially inconsequential to the broader group at 3% of revenues, a symbol of just how much LSEG has evolved over time (more below on how this occurred).

Finally, LSEG’s Post Trade business (14% of total revenue and EBITDA) is comprised primarily of LCH, a clearinghouse for interest rate swaps and other derivatives, of which LSEG owns ~86% with the balance still owned by member banks. Clearinghouses tend to be monopoly businesses as liquidity centralizes around a single marketplace that provides the most efficient means of execution and collateral benefits. While a more mature business, regulation may over time cause more FX derivatives to centrally clear, which could cause an uptick in growth. Management is also excited about driving growth within compression technologies (more sophisticated, algorithmic collateral management) as well as certain reporting functionalities for uncleared derivatives.  LCH is also acting as the clearing partner in BGC’s FMX futures exchange, providing another avenue of potential growth.

Brief Company History

It’s important to understand LSEG’s corporate history in order to appreciate how much the business has evolved in recent years and what may cause investors to incorporate these changes into the company’s valuation. So how did LSEG amass this collection of businesses?

Over the last decade, like many other exchanges seeking to reinvent themselves, LSEG has completed a series of M&A transactions with the goal of becoming a more recurring business. The company’s migration towards a more data-oriented business was greatly accelerated by the acquisition of a business called Refinitiv from Blackstone in 2021 (Blackstone had in turn acquired the business from Thomson Reuters in 2018). The Refinitiv business forms the bulk of the Data & Analytics division discussed above and also included the company’s now controlling interest in Tradeweb.

Under Thomson Reuters ownership – a family-controlled company - Refinitiv was a neglected asset, suffering from poor execution and underinvestment. LSEG’s acquisition of Refinitiv initially got off to a poor start - at close, LSEG acknowledged the business had more tech debt than it initially appreciated which required reinvestment that was far greater than they originally underwrote, sending the stock down 15% in March 2021. After the initial turbulence, execution has since been admirable as management has met or exceeded the various revenue, synergy and profitability targets its set. LSEG has successfully revitalized the business by improving operational processes and investing billions of dollars across product (latency, new data sets, improved UI, AI features, etc.) go-to-market (taking away pricing discretion, incentivizing new business growth) and service areas (better data on underlying customers, greater customer intimacy). The company has also introduced “LSEG Data Agreements” (LDAs) which are bespoke enterprise level agreements with larger customers that bundle LSEG’s various offerings per the customers’ needs. These deals allow customers to consolidate customers’ vendor relationships and reduce costs all on an NPV positive basis to LSEG. These arrangements also lessen LSEG’s exposure to seat-based pricing and the associated volatility from changes in employment levels. Taken together, these initiatives have resulted in improved retention, customer satisfaction, pricing power and increased competitive displacement activity. Under Thomson Reuters ownership, Refinitiv grew at a 0%-2% rate, while under LSEG ownership the corresponding business is growing at a MSD to HSD % rate. While other financials-focused info services companies (i.e., MSCI, FactSet) have bemoaned a weak macro selling environment, LSEG has been winning share.

In December 2022, LSEG and Microsoft announced a 10-year partnership which marked the next leg of LSEG’s business transformation. Operationally, the partnership includes movement of LSEG’s data to the cloud and more importantly, co-development of new product functionality. Initial products developed under this partnership (Meeting Prep, Open Directory – see demos below) begin to be released in H2 2024 and will leverage Microsoft’s AI leadership and render LSEG data as native in the Microsoft Suite, allowing users to access data more easily and streamline tasks such as preparing presentations and prepping for meetings. Of note, interoperability with Microsoft Teams using a to-be-released tool called “Open Directory” – which allows communications between finance firms on existing Teams installations but with a compliance wrapper on top - could cause a loosening of Bloomberg’s chat monopoly. Benefits from this partnership will likely initially be in the form of incremental data/feeds revenue but overtime, we think Workspace retention and installations should improve as well. In conjunction with the partnership, Microsoft acquired a 4% stake in LSEG and received a board seat, signaling its confidence in and commitment to the company.

Demos related to Microsoft features can be found here

Growth and Valuation

As shown below, we believe LSEG can grow revenue at a 6.5% CAGR, EBITDA at a 9% CAGR and EPS at a 13% CAGR over the medium term, with an acceleration in 2025-2027 as benefits from the Microsoft partnership become more tangible. We expect free cash flow per share to grow at an even faster pace of ~24% as free cash flow conversion improves from 50% currently to the low 60’s % as residual Refinitiv integration expenses fall away from the P&L (100m GBP in 2024) and elevated integration-related CapEx normalizes (LDD % falling to HSD %).

Adjusted for the Tradeweb stake, LSEG currently trades at 24x 2024e EPS, a valuation more akin to a financial exchange and one that we do not believe reflects the company’s business transformation. Info service peers - which we believe are the more appropriate peer group given their mission critical, recurring and similar growth profile – currently trade at mid-30’s P/E ratio. As the company’s growth rate and free cash flow conversion improve, we expect LSEG’s valuation to converge closer to the mid to high 20’s P/E, which is the multiple implied by a sum-of-the-parts analysis.

A high 20’s exit P/E in 2027 would result in 60% upside and a 20% IRR. Importantly, given the company’s durable revenue streams and strong secular growth prospects, we believe LSEG has relatively limited downside on a longer-term basis, i.e., organic EPS growth in the low teens should provide downside protection from a slowdown in transaction activity and create cushion against the risk of multiple degradation.

Catalyst

Blackstone overhang removal: as part of LSEG’s acquisition of Refinitiv, Blackstone and its consortium partners rolled over a portion of their equity, becoming a nearly 40% shareholder in the new company. In May 2024, Blackstone effectively exited its long-stand investment in LSEG, removing a key overhang for investors to be the stock (fearing a barrage of secondaries), particularly large, long-only investors that had little appetite to step in front of this. 

Achievement of HSD % revenue growth targets and consistent earnings growth: at its November 2023 CMD, LSEG set medium term guidance MSD-HSD revenue growth from 2024-2027, reaching the high end of the range in later years with steadily expanding margins. The upper end of this range is consistent with info service peers and achieving it, in the eyes of the market, is key to the company’s potential re-rating. We believe the Microsoft partnership and its associated product launches will play a critical role in reaching these goals by accelerating growth within Workspace (improved retention, pricing power and ultimately higher subs driven by product enhancements) and Feeds via increased data subscriptions and add-on products due to cross selling.  Further, in recent years LSEG’s earnings flow through has been muted (revenue +15% from 2019-2023, EPS +10%) due to a litany of largely exogenous factors, namely FX headwinds, divestitures, CS/UBS merger related churn, Microsoft related investments, interest expense increase, tax rate, and Brexit related derivatives volume losses. As these factors dissipate, earnings growth should accelerate and become more visible.

Earnings quality and FCF conversion improvement: one-time integration costs have begun to decline and should be fully out of the P&L by 2026 (currently a LSD % drag on EBITDA). CapEx is also elevated currently due to duplicative tech spend to move LSEG’s vast business to the cloud. As these two items normalize, LSEG’s financials will become much less noisy, FCF should improve and investors should be able to more easily assess and value the business.

Portfolio simplification and/or US Listing: on a more speculative basis, LSEG could eventually opt to simplify the portfolio (to become a pure play data and info services company) and/or pursue a US listing where most of its peers trade. This would encourage US research coverage and make it simpler for US based funds to invest. Note, there is no indication that the company is considering either of these at the moment but it is a topic often written about in sell-side reports.