Description

We believe NASDAQ OMX Group presents a compelling deep value opportunity, currently trading at 9x 2010 EPS.  As of 11/24, the stock is down 20% year-to-date, while the S&P is up 22%.  Furthermore, it has significantly underperformed the peer group, with the NYSE down 5%, the LSE up 64%, and Deutsche Boerse up 14%.  Given the tailwinds the company is experiencing and the significant operating leverage in the business model, we believe the stock has significant upside potential at these levels.

Background

There are a number of contributing factors to NASDAQ's recent underperformance.  Perhaps foremost among them is the weakness in U.S. Cash Equities due to intense competition from Direct Edge and Bats, the increase in internalized trades by broker dealers, and the rise in flash orders.  This confluence of factors has led to NASDAQ's trading market share across the US-listed stocks to fall from almost 31% in the beginning of 2008 to just below 21% in May of 2009.  Revenues from NASDAQ's U.S. Cash Equities business are down 33% through the third quarter of this year.  Another potential reason for the stock price weakness is the negative signal from the recent string of departures among some high level executives at the company.  Among them, the president of OMX, the CFO, the head of equity trading, and the co-head of U.S. Options have all departed the company in 2009.  Finally, we believe that NDAQ is being overlooked by many investors due to the perceived lack of topline growth potential, coupled with the lack of further cost-saving potential.  The company stated on their Q309 call that they have largely extracted all of the synergies from recent acquisitions of OMX and PHLX.

U.S. Cash Equities

It is first worth noting that only 34% of NASDAQ's total revenues are transaction-related, and therefore the vast majority of the company's revenues are fee-based and relatively stable.  Furthermore, the U.S. Cash Equities business is no longer that meaningful to the company, comprising merely 11% of total revenues year-to-date.  Despite this increasing insignificance, the company has recently begun to reverse the negative trends in the business.  The launch of the Boston Stock Exchange (BX), now capturing almost 4% of the market, has contributed to several months of sequential market share growth for NASDAQ.  In October, total NDAQ market share reached 24.8%, a level last seen in February.  Of course, in order to achieve this, the company has had to make significant concessions in the form of lower transaction fees and higher rebates, which led to a 44% sequential decline in U.S. Cash Equities revenues in the third quarter of 2009.  However, the company has recently increase pricing on both the BX and the NASDAQ while holding market share and expects to see a strong sequential increase in revenues in the fourth quarter.

NDAQ OMX Market Share in U.S. Equities:

                   NASDAQ           BX          Total

Jan-08          31.6%          0.0%        31.6%

Jul-08           30.3%          0.0%        30.3%

Jan-08          27.1%          0.0%        27.1%

Feb-09          25.7%          0.1%        25.8%

Mar-09          22.5%          0.3%        22.9%

Apr-09           20.8%         0.8%        21.6%

May-09          19.8%         0.9%        20.8%

Jun-09           19.8%         1.3%        21.1%

July-09          20.1%         2.1%        22.2%

Aug-09          18.6%         2.6%        21.2%

Sep-09          19.4%         3.3%        22.7%

Oct-09           21.1%         3.7%        24.8%

Source: NASDAX OMX

In addition to the above gains, we expect that any regulatory actions taken to restrict dark pools, including a ban on flash orders, will further free up market share in U.S. Cash Equities to be regained by NASDAQ.  A 1% gain in market share should yield a 1-2% increase in 2010 EPS.

Growth Prospects

There are also a number of markets in which NDAQ is expecting to grow.  In the U.S., the company has completed its startup investment in the International Derivatives Clearing Group (IDCG), which will serve as a clearinghouse for the already large and growing OTC interest rate swaps market.  BNY Mellon recently announced a strategic investment in this venture, and its partnership will allow IDCG to accept more forms of collateral.  As of the third quarter, IDCG has received shadow clearing deals worth over $850 billion in notional value, which was up from $450 billion in the second quarter.  On its most recent earnings call, NDAQ quantified the impact that this business will have on revenues once it goes live.  If IDCG can capture $1 trillion in notional value, which represents less than 1% of the total market as of December 2008, this would add roughly $20 million to revenues.  Since NDAQ has already absorbed the operating expenses for this investment, this revenue would flow directly to the bottom line.  The company believes it could ultimately generate additional annual revenues in the hundreds of millions.  In addition to IDCG, NDAQ has recently created another listing venue in the U.S. through the Boston Exchange to cater to companies that fall in between the OTC / Pink Sheets and NASDAQ requirements.

NDAQ also has several initiatives underway with the OMX group in Europe.  The launch of its Central Counter Party (CCP) clearing and the conversion to NDAQ's INET platform in the Nordic region late this year should both lead to increased trading velocity, benefiting NDAQ.  Importantly, NASDAQ OMX has maintained its market share in the Nordics at ~85% since the CCP launch in October.  The launch of NDAQ's UK power market is also imminent, with a number of major power producers already signed on.  The company's London MTF has also been gaining market share, albeit at a gradual pace, reaching 1.5% most recently.

Capital Structure

NDAQ does not currently pay a dividend, unlike the rest of the peer group.  Given the large acquisition of OMX in 2008, the company has been committed to reducing its debt burden for the past several quarters, retiring $435 million this year alone.  As of September 30, 2009, total debt was $1.9 billion, and net debt to EBITDA was 2.2x.  The company also has ~$780 million of cash and investments, of which ~$400 million is restricted and for regulatory use.  While the company generates substantial free cash flow, its existing bank loan covenants restrict it from shareholder-friendly actions.  With the recent upgrade of NDAQ to investment grade by Moody's, we believe the company could have an opportunity to refinance its existing term loan under less restrictive covenants, creating the possibility of a future dividend or stock repurchase.

Valuation

NDAQ is currently trading at 9.3x our 2010 EPS earnings estimate of $2.13, compared to its three-year historical average forward P/E of 17x.  NDAQ is also trading at a discount to NYX and the other peers, as depicted in the chart below.  We believe that this discount is unwarranted given the recent stabilization in the U.S. Cash Equities business and the growth initiatives that are underway.  Given the fixed operating cost business model and NDAQ's best-in-class operating expense management, there should be substantial earnings leverage from any revenue growth the company experiences. 

While departures are always difficult to explain, there is some turnover to be expected during merger integrations, and it appears that the company has hired / promoted strong replacements.  Since Eric Noll joined from Susquehanna in July to run transaction services, U.S. Cash Equities has trended positively and U.S. Options has maintained share.  Furthermore, CEO Bob Greifeld is a longtime leader in the industry and has headed the company since 2003, successfully integrating several acquisitions and extracting significant synergies.

We apply a 13 multiple on our 2010 earnings, representing modest multiple expansion, to arrive at a price target of $27-28.  However, it is important to mention that our 2010 earnings does not include any benefit from the interest rate swaps business.  To the extent this begins to contribute to revenues, there will be further upside. 

Price / 2010 EPS:

NASDAQ                      9.3x

TMX                           11.0x

NYSE                         11.3x

LSE                           13.2x

Deutsche Boerse      13.5x

ICE                           20.4x

CME                         20.9x

Source: Bloomberg

Catalyst

• Regulatory action banning flash orders and restricting dark pools
• S&P upgrade from December review, which could further pave the way for refinancing
• Any legislation favoring clearinghouses in the interest rate swaps market
• Revenue rebound in U.S. Cash Equities, demonstrating that the business has truly stabilized