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NDAQ: Are they getting any credit for their LSE LN investment?
NDAQ has a $1.6BB ($10/share) investment in the London stock Exchange (LSE) for which I believe they are getting no credit from the market. The valuation of NDAQ is obscured by this investment and the true economics of the LSE investment are not reflected in NDAQ’s earnings. At some point this value will be unleashed. Admittedly NDAQ’s domestic business has plenty of challenges (I won’t attempt an exhaustive discussion of market structure in this note) but I think these are discounted in the current valuation.
The very quick background:
Over the past year NDAQ has acquired 62MM shares in LSE (~29%). LSE management has refused to meet with NDAQ or discuss a merger. NDAQ made a tender offer for LSE at 1243p that concluded unsuccessfully on Feb 10th. Due to UK takeover code, NDAQ cannot make another unsolicited tender offer for LSE for one year.
The 62mm shares are worth ~$1.6 BB at the current market valuation. NDAQ recognizes only dividend income from LSE. They do not recognize a proportionate share of LSE’s profits or any mark to market gains/losses on their investment. This materially understates the returns generated on this investment.
A couple of different ways to look at valuation and potential scenarios:
1) Sum of the parts: NDAQ’s $1.6 BB investment in LSE is worth ~$10/share or a third of NDAQ’s market cap…yet again NDAQ recognizes minimal income and incurs significant debt costs to finance the investment. The LSE investment was financed with debt, however the debt burden of about 3.5x NDAQ's stand alone EBITDA is totally manageable and prudent for NDAQ by itself. NDAQ doesn’t recognize earnings from LSE and the LSE stake could be (I think should be) looked upon as a separate asset in addition to the stand alone valuation of NDAQ. Backing out the value of the LSE LN stake from the NDAQ market cap implies that the US NDAQ operations are valued at just ~12x '08 consensus earnings.
2) Equity method of accounting: NDAQ owns 29% of LSE but due to their lack of control and the inability to get quarterly LSE financials the investment is not accounted for under the equity method as would normally be the case with an investment of that size. NDAQ recognizes only dividend income from LSE but is saddled with the full debt load that finances the investment. If the accounting treatment was different and more closely reflected the actual economics then NDAQ would recognize 29% of LSE's earnings (projected at £111 MM in 2007). Net of the dividend this would increase NDAQ’s EPS by approximately $0.20. This is not insignificant in the context of NDAQ consensus estimates of $1.38 in 2007.
3) What if they sell the position? This doesn’t seem to be the thinking right now but things could change. There are at least three options if they punt the LSE stock:
a) Sell position and pay off debt? Assuming they sell the LSE position at a 15% discount to the market (totally arbitrary…substitute your own view) they would raise ~$1.4 BB. If this was used to pay down debt, eps would increase by about ~$0.30 (20%) net of the foregone LSE dividend.
b) Sell the position, keep the debt and buyback stock. If we assume the same sale proceeds as above, NDAQ could repurchase about 44 MM shares or 30% of its market cap. Debt level would only be ~3.5x EBITDA and perfectly prudent. They could buy back ~43mm shares or 28% of the market cap. '08 EPS would go from $1.74 to $2.28 assuming no other changes
c) Sell the position to buy something else. OMX SS? ISE? I don’t know. I do know that the market likes mergers in this space and any deal would be better than being stuck in an illiquid position where mgmt doesn't want to talk to them.
3) Maybe NDAQ is a target? Global consolidation of exchanges is clearly well underway and LSE is obviously a strategic asset. Maybe NDAQ becomes a target. Valuation is compelling and it also gives the acquirer a foothold in LSE LN. Perhaps LSE would seem more strategic value in a 3-way tie up with a consortium of exchanges that could compete with NYX/NXT FP?
4) NDAQ could work with hedge funds/others to get a deal done: NDAQ has 29% of the stock. If they could corral the support of another 20% they could call an EGM and begin to more seriously pressure and/or replace LSE LN board members. NDAQ would likely need to pay a premium to their previous 1243p offer but if it was a negotiated deal for 100% of the company I think they could and would do it.
5) Status quo. Nothing happens for a while. NDAQ sits on the LSE stake in the hopes of negotiating a deal a year from now. In the short term this leaves lots of question marks. Still, while I perceive this as a negative scenario, this is the status quo and the outcome expected by the market and the financial forecasts. I think the stock does very little and we don’t get hurt in this outcome…but any deviation from this outcome seems to produce positive results
This note is about the valuation of the LSE LN position within NDAQ and I won’t attempt to provide a complete discussion of market structure and the many challenges and opportunities that confront NDAQ. I will concede that US cash equities represents a non-captive liquidity pool and one in which market share shifts and pricing pressure is likely to continue. Would note however that this is not a new threat to NDAQ. NDAQ only has about a 44% market share in Nasdaq listed stocks…and it only acquired this market share through the acquisition of INET. The Nasdaq market has been an extremely fragmented and competitive marketplace for some time. BATS and others are legitimate threats, but they are not new threats. Island, Instinet, Direct Edge and dozens of others of ECNs have existed for some time…and many have been successful along-side of NDAQ…but not to NDAQ’s detriment
Also worth noting that while BATS has made considerable progress in gaining share most of it has not come from NDAQ but rather other ECNs and from internalized trades.
NDAQ has also been gaining share in NYSE listed stocks. Relative to NDAQ, NYX has operated in a largely protected environment until recently as much of its order-flow was captive on its floor. This has changed rapidly over the past year and will continue to change with the introduction of Reg NMS. Because NDAQ has been already been operating in an intensely competitive environment for many years, I believe that Reg NMS and the competitive threat from new entrants will have a more significant effect on NYX relative to NDAQ.
NDAQ sold off earlier this month due to disappointing guidance. Upon examination would just note that they are still guiding to :
11% top line growth in 2007 (gross margin of $755-775 which conservatively assumes flat Nasdaq-listed volumes)
A 9% decrease in expenses (total expenses of $390- $410)
And a 44% increase in net income in 2007
This still seems like a pretty decent growth company near-term.
I don’t know how the value of the LSE position will be unleashed, but I do think that it is underappreciated and undervalued within NDAQ. Given that it represents a third of NDAQ’s market cap I think we could see some considerable upside if they manage to monetize the position.
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