Description

a.     Summary of the business (what does NEX Group do?)

          i.          The Group level

1.     NEX Group (formerly ICAP) is a UK-listed financial exchange with a market cap of c. £2.1bn and revenue of c. £0.5bn

2.     ICAP recently sold its large Voice Broking operations to Tullett Prebon (“TP”). Voice broking is an operationally geared, secularly challenged business. The sale to TP made strategic sense for both parties. As part of the divestment, TP acquired the brand name ICAP, hence the change of name to NEX Group

3.     NEX now has two main divisions: (1) NEX Markets (offering electronic trade execution for government bonds, repos and FX), and (2) NEX Optimisation (transaction life-cycle management services and information services to optimise portfolios and control risk, as well as a fintech investment business, called Euclid Opportunities)

4.     NEX’s main customers are investment banks, asset managers, interdealer brokers, corporate treasury teams and central banks. NEX has over 1,800 employees, spread across the globe (the UK, US, Sweden, etc.)

5.     NEX has a 31^st March financial year end. Any date references are to FYE 31-March unless otherwise stated

         ii.          NEX Optimisation (c. 45% of revenue, c. 50% of profit, growing mid-single digits on a secular basis)

1.     NEX Optimisation is made up of a collection of high quality ‘post-trade’ businesses with secular growth opportunities

a.     NEX Optimisation enable users of financial markets to reduce operational and systemic risk, helping customers increase trading, clearing and settlement efficiency and lower related costs in these key activities

b.     NEX Optimisation is well-positioned to benefit from the secular trend of more financial regulation. For efficiency reasons, many customers are increasingly interested in “one stop shop” service providers that can improve the customers’ operational efficiency through the whole life of a transaction: NEX is well-positioned to capitalise here

c.      NEX Optimisation also offers information services, which takes pricing and instrument data from the NEX Markets business and delivers it to customers to enable trading decisions across key asset classes

d.     Lastly, NEX Optimisation includes Euclid Opportunities, a fintech focused VC business. Clearly, this business is a hard to model and hard to value, given the early-stage investments it makes. This business is potentially undervalued: NEX does not break-out the losses from Euclid in the P&L, which means investors are arguably capitalising the current negative profits of this business when, instead, they should be valuing its growth potential. Euclid could actually be worth c. 5 to 20% of the market cap, given (a) the capital invested so far in the business and (b) the market capitalising the negative temporary profits. This mispricing should hopefully change over the coming quarters, as management has stated it’ll improve transparency here starting at the May 2017 CMD

2.     The segment should have high operating margins (high 30s, low 40s) on a normalised, mid-term basis

3.     NEX Optimisation’s revenues profile is fairly stable: only c. 10% is directly linked to end-market trading volume. The segment has been growing the top-line at a high single digit CAGR for the L5Y, and this should continue in the mid-term. I assume c. +5% growth p.a. (somewhat conservatively; there is big scope for that to be beaten)

4.     This area of the financial ecosystem is ripe for further M&A. Both for NEX, as an acquirer of early stage technology, and NEX as a target: larger exchange groups have expressed interest in the past in NEX’s post-trade optimisation businesses

       iii.          NEX Markets (c. 55% of revenue, c. 50% of profit, growing low-single digits on a secular basis, with cyclical optionality)

1.     This division comprises EBS and BrokerTec, NEX’s electronic platforms. They cover a range of asset classes, primarily foreign exchange (EBS), US Treasuries and Repos in the US and Europe (BrokerTec)

2.     EBS and BrokerTec have suffered from structural and cyclical headwinds in recent years, which have pressured trading volumes in FX and government debt since 2010

a.     Structurally, some of NEX’s key trading partners, e.g., banks and investment banks, have pulled back from proprietary trading in the face of a wave of post-crisis regulation, reducing trading volumes

b.     Cyclically, interest rates globally have been suppressed as government and central bank monetary policy has sought to spur economic growth, which has limited participants desire to trade FX and Treasuries

c.      Levels of volatility across NEX’s markets have been extremely low. Whilst this is not ideal, it means trading volumes are unlikely to fall much further, and could potentially rebound aggressively if there is a US rate hike cycle. As such, there is a high probability (greater than c. 70%) that we’re near a cyclical trough in revenue growth for the segment

3.     NEX Markets is highly operationally geared (with high fixed costs). Given the likely N1Y skew in potential trading volumes over the N2Y, there is a positive and asymmetric distribution re. the N2Y earnings progression of NEX Markets

4.     The segment has delivering operating margins over 40% in the past, but these have fallen to c. 33% in 2016A and c. 31% in 1H 2017A (a result of a major investment programme over the L3Y, which NEX says is now coming to fruition)

5.     The segment has been flat to growing low single digits for the last few years. I assume c. +3% secular growth over the mid-term

b.     Key drivers: what's the investment hypothesis in 30 seconds

          i.          NEX is a transformation that remains somewhat misunderstood, but hopefully not for much longer

1.     NEX has just gone through a major corporate separation (sale of Voice Broking to TP)

2.     As NEX transitions to a pure electronic exchange and post-trade focused business, with incremental post-tax returns on capital of c. 45%, the market should begin to appreciate NEX’s structurally advantaged competitive position and the share price should re-rate accordingly

3.     Management is hosting a CMD in May, alongside full year results. This should help investor sentiment to inflect positively, as more and more investors become educated on the upside potential at NEX

         ii.          Management’s ‘base case’ suggests c. 50%+ upside

1.     Management target c. +10% revenue growth and c. 40% operating margins (vs. 32% currently) in the mid-term

2.     If this is delivered and NEX trades in line with peers, the upside is tremendous: c. 50 to 75% upside, plus dividends

       iii.          There are short-term cost saving opportunities that the company should update the market on N6M

1.     Management have probably taken their eye off the ball a bit re. cost control, given the recent major  corporate transformation. This should change in the coming year, and we should get more of an update at the May CMD

       iv.          Compelling fundamental skew: ‘heads I win, tails I don’t lose much’

1.     NEX has some nice structural tailwinds (increasing regulation favouring ‘one stop shop’ solutions, ala NEX), which should drive low single digit top line growth on a mid-term basis

2.     The company is geared to a rate cycle turn (cyclical upside). Trading volume in NEX’s end markets are at multi-year lows. Any uptick in market volatility (e.g. a rate rise cycle or an increase in intra-region interest rate differentials) and revenue growth will fall through to profits at a 3:1 ratio, given the company’s high operating leverage

3.     The scope for major EPS growth (i.e. greater than c. +20%) in the mid-term is substantial

         v.          Even assuming no cyclical growth, I still think NEX can grow EPS at c. +15% p.a. and eFCF by c. +20% p.a. to 2020E. Growth is substantial, even without a  cyclical uptick in end market volumes

       vi.          The company is a clear M&A target (esp. as LSE/DB1 has broken)

      vii.          All that said, the share price has been fairly volatile over time (and somewhat range-bound, on a 10Y view), which suggests to me the need to ‘trade it well’ as opposed to ‘closing your eyes and buying and holding’

c.     Business quality assessment: how good a business is NEX?

          i.          NEX’s businesses have strong moats and competitive positions, deep customer relationships and  are highly cash generative

         ii.          NEX Optimisation

1.     Has been growing at high single digits for the last five years

2.     The segment benefits from strong, secular growth tailwinds. Only c. 10% of segmental revenues are cyclical

3.     The businesses are well-regarded by customers and competitors, has shown a good record of innovation, and has been integrating itself more and more into the customers’ businesses (increasing its customer-based competitive advantage)

4.     Returns on capital are very high, leading to high amounts of cash flow

5.     The segment would be a highly prized acquisition target for many of the larger exchange groups, with historical transactions in the sub-sector going for well over c. 25 or 30x P/E

d.     NEX Markets

1.     Has suffered from major headwinds in trading volumes, with revenue having fallen by c. (1)% p.a. for the L3Y

2.     This headwind has been market-wide, driven by a global reduction in FX and government debt volatility (reducing the need for trading/hedging of these securities). Regulation (e.g. the Dodd-Frank Act) has also led to a reduction in risk taking at major financial institutions, reducing trading volumes

3.     Against this market-level headwind, NEX has been taking share and growing into new verticals/products, offsetting market-level decline. Innovation has been strong and NEX has just finished a large, multi-year investment push in NEX Markets. Management now expects to reap the rewards over the N3Y with fairly limited investment requirements

4.     I think we are near ‘record low’ levels of trading volumes, which suggests an attractive skew if volatility picks up

5.     All this considered, revenue growth is fairly cyclical. Combined with a high degree of operating leverage, there is scope for the segment’s profit margins to expand materially if end-market volatility picks up

6.     The segment is also highly cash generative, with high return on incremental investment

7.     The business is similar to cash-equity exchanges. It would be a viable target for many of the large exchange groups, but is less of a jewel than NEX Optimisation (and therefore should command a lower fair multiple, though precedents in the sub-sector have actually transacted at fairly punchy multiples: over c. 25x P/E in many cases)

e.     Management quality assessment: how good are the leaders? 

          i.          Management quality is very good (as is the BoD). They talk very sensibly about shareholder value creation

         ii.          NEX is run by Michael Spencer, who founded the business c. 30 years ago and owns c. £375m of equity

1.     He is a classic owner-operator, with incentives that are firmly aligned with ours

       iii.          Given his age (c. 60 years old), Spencer is also likely looking for an elegant exit path over the N3Y (i.e. a trade sale)

f.      What is causing the mispricing? What's "Mr Market’s" misunderstanding?

          i.          NEX is a transformation. The sale of Voice Broking means the future looks different (better) vs. the past

1.     Return on capital is higher than before

2.     Operating leverage is lower than before

3.     Secular growth prospects are much better than before

4.     The probability of being an M&A target has increased dramatically (Voice Broking was unattractive to acquirers)

         ii.          There has been a temporary disruption of the normal flow of information after the transaction

1.     e.g. no pro forma financials are available, yet

2.     e.g. some sells-side estimates are still outdated (for ICAP, incl. Voice Broking)

3.     This will change with FYE 2017E results and a CMD in May

       iii.          Cost control / margin concerns can easily fall away from investors’ minds with a quarter or two of ‘good delivery’

       iv.          FX volatility could be confusing the market

1.     NEX reports in GBP but generates most of its earnings in USD. Clarity from NEX has been lacking, which may be leading to a misunderstanding in the temporary, recent volatility of NEX’s reported earnings around Brexit

g.     Margin of safety and potential returns assessment:

          i.          I estimate c. 10 to 15% potential IRRs over the N2Y in a ‘no cyclical growth’ scenario (i.e. a quasi-‘grey sky’ scenario)

         ii.          If end-market volatility picks up, the possible IRRs are c. 30% over the N2Y

       iii.          Given the share price is somewhat cyclical/volatile, there is scope for the share price to ‘over-shoot’ the fair price. If the ‘stars align’, we could see the share price going beyond c. +75% from today’s price

       iv.          Significant cash flow and limited leverage means that cash returns are likely to be plentiful: I believe NEX can / will distribute c. 8 to 10% of the market cap. each year to shareholders

         v.          The fundamental ‘grey sky’ case is unlikely over N2Y (c. 10% probability) and the downside looks fairly limited, at c. (10) or (15)% (again, triangulated via numerous methodologies)

       vi.          That said, the share price is volatile and I think the share price could bounce down if earnings disappoint

Below are some ways to think about valuation. Firstly, EV/IC vs. ROIC/WACC. Good for through the cycle analysis. even w/o NEX Market cyclical growth, lots of potential upside. 

Fair value in the "quasi grey sky" scenario, where there is no NEX Market uptick. 

Below is the fair potential value if the NEX Market business does inflect, as we think is highly possible.

Here's another way of sensitising the fundamentals and fair share price, based on various levels of NEX Market growth (ie. sensitising the cyclical growth in that business)

h.     Risk assessment (identifying potential land mines):

          i.          Earnings are volatile, given the operating leverage

         ii.          End-market volatility does not look like it is picking up here and now; there is scope for earnings to disappoint and/or shorter-term speculators/traders to sell their holdings

       iii.          The investment thesis is one of transformation: e.g. the margin improvement thesis increase execution risk

       iv.          The share price is much more volatile than the underlying intrinsic value, so intelligent position management is key

         v.          The whole sector’s trading multiples have expanded since 2011, creating more fragility to any risk-off behaviour in market sentiment

NB: this is the summary section from the front of a more detailed 50 page memo. I'm happy to share that, if of interest. Sorry if any of the sections are skirted over in too little detail (that seems to be the way VIC write ups are these days).

I look forward to your feedback + thanks for taking the time to read it. 

Catalyst

NEX as a high probability bid target

CMD / FY 2017E results in May 

Operational delivery