Description

Overview

Nearly two years have elapsed since we first pitched TASE, a write-up you can find here: https://www.valueinvestorsclub.com/idea/Tel_Aviv_Stock_Exchange/8002569252.  Enough has transpired that we felt it was time to provide an update on the company and pound the table once again for what we believe is a terrific investment.  (Apologies to VIC for double-dipping on the same idea in the span of two years, but this is our highest conviction idea.  We didn’t see the value in writing up something else.)  Below we’ll review the company’s recent operating performance and delve into the recent underperformance in TASE shares that is providing what we believe to be an excellent opportunity. 

In terms of business performance, the company’s results have been excellent.  Since the company’s IPO in 2019, revenue and adjusted EBITDA have grown at 11% and 29% CAGRs, respectively, in-line with our original underwriting.  2022 results were especially strong as we discuss below.  On the capital allocation front, TASE has exceeded our expectations.  Last year, the company scrapped its regular dividend and implemented a share repurchase program which has allowed management and the board to capitalize on the stock’s heavily discounted valuation.  A third aspect of our investment thesis was that the company would monetize certain hidden assets, most notably through the sale of shares held by pre-IPO shareholders. These so-called “Arrangement Shares” entitle TASE to much of the cash proceeds in a sale and are therefore valuable as both a source of cash and improved liquidity in the stock.  Despite its best efforts, management has so far been largely stymied on this front.  We’re optimistic that a resolution is forthcoming as management works with a new regulator to resolve the Arrangement Shares overhang. 

After a strong showing last year, TASE shares have underperformed in 2023 in large part because of angst over controversial judicial reform efforts in Israel.  We have no special insight into how this debate ends, but furious pushback to Netanyahu’s reform proposals by a wide swath of the Israeli population (and the U.S., a key ally) suggests that compromise is likely.  Judicial reform has no direct bearing on TASE, so when the smoke clears, we expect much of the recent pessimism toward the company will too.  TASE can and is taking advantage of the situation by accelerating share repurchases at depressed prices.  From the initiation of the buyback program in May 2022 until early August 2023, the company repurchased over 9% of its shares at a ~20% discount to the current share price.  This is music to our ears as it accelerates per share intrinsic value growth.   

Thesis Update

To briefly review our investment thesis, TASE is early in its evolution as a privately-owned, for-profit enterprise.  Historically, the company operated as a member-owned, not-for-profit entity.  Strategic and financial decisions were made to benefit members, primarily Israeli banks, not the exchange.  TASE’s recent demutualization and subsequent IPO reduces conflicts of interest and increases the company’s freedom to operate as an independent, standalone entity.  In terms of the core business, TASE has significant opportunities to launch new products and services, optimize pricing, and drive efficiency gains.  We expect considerable value creation over time from the combination of healthy revenue growth and margin expansion.  With respect to the latter, TASE’s margins are well below peer levels, providing a long runway for improvement.  There are also hidden assets that we believe are worth nearly 35% of the company’s current market cap that can be monetized over time.  Management and the board are highly incentivized to create value and are making strides in this direction.  Finally, TASE could be an acquisition target for a larger global exchange.

As noted above, our investment is tracking well in terms of fundamental performance.  TASE continues to benefit from structural tailwinds in the Israeli economy and capital markets, while actions by management to expand revenues and profitability are yielding solid results.  From 2019 to 2022, TASE grew revenue, adjusted EBITDA, and adjusted EPS at CAGRs of 11%, 29%, and 32%, respectively.  Total revenue grew 12% in 2022, slightly above our long-term expectation, with strength across the company’s various business lines.  Roughly 40% of revenue came from trading and clearing commissions that vary with trading volumes.  These transactional revenues grew 9% on the same number of trading days in 2022 as 2021.  The remaining ~60% of revenue consists of registration and trading fees, clearinghouse services, and data fees.  These non-transactional revenues grew 13% in 2022, though growth has decelerated somewhat in 2023 as capital markets activity has moderated.  Despite the recent slowdown, management continues to execute on opportunities within its control, most notably pricing.  As a reminder, TASE’s history as a mutually owned exchange meant that pricing was kept low to benefit members.  Many products were provided for free.  The result is that the company’s pricing is very low relative to peer companies.  For example, TASE’s pricing for indices is only about 15% of S&P/MSCI levels, while derivatives pricing is 30-40% of peer levels.  We estimate that normalizing pricing to peer levels across the company’s full range of products and services would boost the current revenue base by ~70%.  Profitability on this additional revenue would be extremely high, all else equal.  In September 2022, the Israeli securities regulator approved a ~5% price hike for indices that phases in by 2024.  Assuming this falls entirely to the bottom line, adjusted EBITDA and EPS would increase roughly 15% and 25%, respectively, compared to unaffected 2021 results.  While the pricing opportunity is huge, we expect that management will pull this lever gradually, as it appreciates the need for a prudent approach given TASE’s monopoly characteristics and a still nascent regulatory environment.  We continue to believe that the combination of structural tailwinds, new product development, and pricing initiatives should drive double-digit top-line growth for many years.  

Turning to profitability, TASE’s adjusted EBITDA margin expanded 560 bps in 2022, with continued expansion in 2023 despite some moderation in revenue growth.  Once again owing to its history as a mutually owned not-for-profit, TASE has very low margins compared to peer exchanges.  Until recently, the company’s revenue base was sorely under-monetized, both in terms of pricing and the range of products and services available, and its cost structure was inefficient. While TASE’s adjusted EBITDA margins have expanded 1,450 bps since 2019 to approximately 38% currently, we believe the remaining opportunity is even larger, with margins that should reach 55-60% over time.  Double-digit revenue growth juxtaposed against strong cost controls should continue to result in impressive operating leverage and margin expansion.  

In terms of capitalization, TASE remains in excellent shape with excess cash equal to nearly 10% of the company’s market cap and zero debt.  As previously noted, in March 2022 TASE discontinued its regular dividend following the 2021 payout.  At the same time, the company announced a 100 million ILS share repurchase plan (~7% of the market cap) to be implemented over two years beginning in May 2022. For the remainder of the year, the company allocated capital at a measured pace, repurchasing 1.9 million shares, or ~2% of shares outstanding. During 2023, management accelerated the pace of repurchases in response to the swoon in TASE’s stock price, repurchasing 7.7 million shares, or more than 7% of shares outstanding.  All told, the company has directed nearly 175 million ILS towards share repurchases in approximately fifteen months.  Yet TASE remains awash with excess cash and capital.  Based on the company’s significant excess liquidity, robust free cash flow generation, and value from the monetization of hidden assets (discussed below), we estimate that TASE could return half of its current market cap to shareholders over the next several years.

As we discussed in our previous write-up, TASE has a pair of valuable hidden assets. The first is an unusual structure that entitles the company to cash proceeds upon the sale of Arrangement Shares held by a group of pre-IPO shareholders (primarily Israeli banks).  The Arrangement Shares entitle the holder to a maximum of 5.08 ILS per share, with excess proceeds going to TASE upon a sale.  Currently these shareholders own ~19% of the company.  If these shares were sold at the current price, TASE would receive cash proceeds of ~194 million ILS, or ~14% of the current market cap.  We expect management and the board to ramp up their lobbying of both the new securities regulator and lawmakers to compel the banks to sell their Arrangement Shares as envisaged by the original legislation that privatized TASE.  The second hidden asset is the company’s owned real estate, specifically its corporate headquarters in downtown Tel Aviv.  TASE owns the building, which we believe is worth ~400 million ILS net of taxes, or nearly 20% of the current market cap.  The company could monetize the property through a sale-leaseback or simply raise capital by taking out a mortgage on the building, which is currently unlevered.  That said, the company currently has ample cash and liquidity even before a sale of the Arrangement Shares, minimizing the need to tap this source of value in the near term.  All told, we believe these sources of value are worth more than 700 million ILS, or nearly 35% of the current market cap. 

Last but certainly not least, TASE increasingly bears the hallmarks of owner-operator models.  U.S.-based investment firm Manikay Global is TASE’s lead shareholder and owns ~19% of the company.  Salah Saabneh, a Manikay partner, sits on the board and has helped to steer capital allocation decisions and overall governance since before the company’s IPO.  Management also has considerable skin in the game.  In March 2023, TASE’s board implemented a retention plan for the company’s CEO, Ittai Ben-Zeev. We have a high opinion of Mr. Ben-Zeev, who has been instrumental in reshaping TASE since he was hired in 2017.  We were thus pleased to learn that the company granted him approximately 0.5 million warrants that are exercisable into common shares after five years with a 40.00 ILS strike price.  For these warrants to be in the money, TASE shares must appreciate more than more than 80% from today’s price. These warrants are in addition to the 4.25 million warrants the board granted to Mr. Ben-Zeev prior to the IPO.  This block of warrants has a strike price of 12.00 ILS per share and is exercisable in 2024.  In February 2023, the board also approved a plan for the grant of warrants to additional members of the TASE management team.  Approximately three million warrants were granted to nine officers reporting to the CEO; these warrants are exercisable into common shares at a strike price of 24.39 ILS per share in three equal annual batches beginning twelve months from the date of the grant.  In aggregate, Manikay, Mr. Ben-Zeev, and the rest of TASE’s senior management team own more than 25% of the company.  We believe this creates strong incentive alignment with shareholders and a focus on generating lasting value at the company.

Valuation and Return Profile

Despite a strong first half of 2023 in terms of business performance, TASE shares are down ~4% in local currency this year as investors fret over proposed judicial reforms in Israel.  The combination of rapid profit growth and a weak stock price has driven the company’s headline valuation down to less than 10x our 2024 adjusted EBITDA estimate.  This is a roughly 25% discount to global exchange peers even though TASE has superior revenue growth and margin improvement potential.  But those figures don’t tell the whole story.  To start, the company’s headline multiple excludes any value from its sizable hidden assets. Assigning full credit to value from the Arrangement Shares and owned real estate reduces TASE’s enterprise value by about 35%, to approximately 6x 2024 adjusted EBITDA.  Even more significant, however, is the gap between prices charged by TASE and other global exchanges.  We estimate that normalizing pricing to peer levels would increase the company’s current revenue base by about 70%.  The corresponding uplift to adjusted EBITDA would further reduce the valuation to less than 3x 2023 adjusted EBITDA.  We acknowledge that this valuation exercise is illustrative, especially the pricing opportunity, which will likely play out over years, not all at once.  But it highlights what we believe is an extraordinarily inexpensive valuation for a monopoly financial infrastructure asset.  We believe the combination of strong revenue growth, significant margin expansion, accretive capital deployment, and monetization of hidden assets should drive substantial intrinsic value growth in the years ahead.  There is further (admittedly lower probability) optionality in a takeout, as we think TASE is a logical acquisition candidate for a larger global exchange. Such transactions have historically occurred at sizable premiums due to significant cost synergies. 

In a little more than four years (i.e., 2028) we believe TASE can earn approximately 2.85 ILS per share, to which we assign a 20x multiple, valuing the operating business at nearly 57 ILS per share, or a conservative 25% 4-year IRR excluding all the company’s non-operating assets.  Were we to give full credit to TASE’s non-operating assets including its excess net cash balance (7.3 ILS per share), Arrangement Share proceeds (4.5 ILS), and owned real estate (3.4 ILS), total per share value is approximately 72 ILS, or a 32% 4-year IRR.  (Note: for those of you paying close attention, our estimate of 2026 EPS in our 2021 VIC write up was 1.85 ILS; it’s now 1.96 ILS).

The bottom line is that we believe TASE is a cheap stock.  The current valuation bears little relation to the company’s status as a monopoly financial infrastructure asset serving a dynamic and growing economy. TASE grows faster than other global exchanges, has vastly more margin upside, and yet trades at a large discount.  And this is before considering optionality from the company’s sizable net cash position and hidden assets waiting to be monetized.  We see highly attractive long-term return potential.

We and our affiliates are long TASE.  We may buy or sell without notification.  This is not a recommendation to buy or sell shares.

Catalyst

• Steady progress on top-line initiatives coupled with strong expense controls resulting in continued operating leverage as margins track towards peer levels
• Monetization of hidden assets
• Further capital allocation into accretive share repurchase
• Acquisition by a larger global exchange