Tullett Prebon (“Tullett”) is the world’s second-largest inter-dealer broker, which the market has recently put on sale at all-time lows.   Tullett is an overlooked spinoff that begin trading on the London Stock Exchange in December 2006.  Adjusting for regular and special dividends, the market in recent weeks has driven Tullett more than 5% below its price at the time of the spinoff, and Tullett is now available at a compelling valuation on both an absolute basis and relative to its peers (and described as a “hidden gem” by someone from the industry).   

 

I believe the market is overreacting to three recent data points: strength in the GBP, which led the company to guide for lower reported revenue growth in 2007 (~50% of TLPR’s business is USD denominated or linked); the apparent failure of Tullett’s bid for electronic rival ESPD (an opportunistic, lowball bid made after activists briefly went after ESPD, and with full knowledge that ESPD’s voting rights are in the hands of rival BGC Partners and that the bid therefore had very low odds of success); and Tullett stating that it will increase 2007 investment in its Tradeblade electronic trading service to GBP 15mm, coupled with a slow start by Tradeblade in the US repo market.

 

I think the market is missing the bigger picture for Tullett: voice-broking of complex OTC derivatives (their main business) is *not* disappearing the way voice broking is for equities; in fact it is a growth business, as the volume and complexity of derivatives instruments has grown dramatically in the last decade and continues to grow, driven by increases in proprietary trading and by changes in risk management practices at banks and corporations, particularly with changes Basel II is making in how core capital is accounted for at banks.

 

Inter-dealer brokers are intermediaries (“broker’s brokers”) in the wholesale global financial markets, whose clients are professional traders, i.e. commercial banks, investment banks, hedge funds and buy-side institutions.  Tullett primarily brokers trades involving interest rate derivatives, foreign exchange, and fixed-income securities.   Inter-dealer brokers benefit from increases in volatility, volume, and complexity in the financial markets.

 

1  TLPR is undervalued on both an absolute basis and relative to its peers, trading at 8.6x estimated 2008 EBIT and 13.1x estimated 2008 earnings (which for TLPR is a proxy for free cash flow), while likely to be able to grow revenue at 7%-9% annually, and to have a long-term EPS growth rate of over 10% due to operating leverage.  Coupled with a high return on equity (28%), and a commitment to return free cashflow to shareholders, I think we can expect significant gains from TLPR as a standalone business.

 

2  However, TLPR is also likely to benefit in the near- to mid- term from market consolidation among and between inter-dealer brokers and exchanges, and there is a decent probability that it is acquired by a larger rival or partner in the next couple of years.

 

3  TLPR has the unusual property of being a beneficiary of increased financial market volatility, as its products are used by its customers to manage and speculate on risk and changes in interest rates.  Therefore it can act as a “natural hedge” against other positions in a portfolio (but, of course, has outlier downside risk from settlement failures etc).

 

 

TLPR was demerged from its parent, Collins Stewart Tullett plc (formerly CSTL_LN) on December 14,  2006.  Collins Stewart Tullett included the inter-dealer broker business of TLPR as well as the institutional and private client stockbroker business of Collins Stewart (now traded separately as CLST_LN).  Collins Stewart itself went public in 2000, and acquired Tullett Liberty in March 2003.  The Tullett business was founded in 1971 and was originally focused on the foreign exchange and money markets.  During the 1970s and 1980s, Tullett developed a number of overseas offices and expanded its operations as an intermediary in the wholesale financial markets, including interest rate derivatives.  In 1999, Tullett acquired Liberty Brokerage, a fixed-income dealer based in New York. 

 

Collins Stewart Tullett acquired the Prebon inter-dealer broking business in October 2004, and rebranded the combined business Tullett Prebon.

 

TLPR recently received regulatory permission to reduce its capital (as it does not take principal risk but only acts as an intermediary), and paid out a special dividend to shareholders in March 2007 of GBP302mm (about 141p per share).  The CEO has stated that he is interested in continuing to use the balance sheet to pay special dividends on top of ordinary dividends.  The recap/special dividend brought leverage from net cash to closer to 2x net debt/EBITDA (but given its strong free cashflow generation, TLPR should be able to delever quickly at close to 0.5 turns/year). 

 

We believe Terry Smith is a highly-motivated owner-CEO who is interested in maximizing his sizable (~USD90mm) position.   He has already leveraged the balance sheet to make one extraordinary dividend to shareholders, and has indicated he is focused on returning value to shareholders (which his large personal shareholding makes quite believable).

 

 

 

Companies that play a role in the global financial market structure, such as retail brokers, equity and derivatives exchanges, ECNs, specialists, etc. have been in a state of rapid change and consolidation over the last few years, as has been explored in the VIC threads on LaBranche, the Chicago Mercantile Exchange, Knight Trading, and others.  The primary driver has been the rise of electronic trading in many instruments coupled with exponential growth in volume and complexity of financial markets, which arises from a combination of algorithmic traders who trade at extremely high volumes, hedge funds and investment bank proprietary trading operations that trade as principals in a high volume and in a wide range of instruments, and the expanding use of derivatives for commercial hedging and for risk control for banks. 

 

There are three main themes in this evolution of the market structure:

 

1  Electronicization, where non-custom financial products (such as equities, commodities, US treasuries, etc.) have rapidly moved from lower-volume, higher frictional cost, semi-anonymous voice-trading models to high-volume, near-zero frictional cost, and highly anonymous electronic trading models.  For example, algorithmic and other computerized trading is now estimated to account for up to 30% of the daily volume on the US stock exchanges.

 

2 Disintermediation, where direct-access electronic trading, sidestepping traditional broker-dealers in many cases, has supplanted indirect-access voice brokerage, radically cutting commissions for brokers and specialists, and in many cases driving them out of business. 

 

3 Transparency, where prices and depth of market information are now widely available where this information was once proprietary to intermediaries such as specialists.

 

These three trends have greatly improved the liquidity, price efficiency, and frictional costs in the global markets, while also increasing opportunities for traders while decreasing the opportunities for traditional market intermediaries, and thus encouraging even more trading.

 

Merger and acquisition activities following these themes include the NASDAQ stock market’s going public and purchasing ECN rivals Brut and Inet, and its failed bid for the London Stock Exchange.  Likewise, the NYSE has demutualized, gone public and acquired electronic competitor Archipelago and the European exchange Euronext.  Private equity firms, buy-side and sell-side institutions and hedge funds have bought substantial stakes in the ECNs and national and regional equity and derivatives exchanges, and funded startups such as BATS.

 

Meanwhile, traditional voice-brokerage-related or very “offline” operations such as NYSE specialists (e.g., LaBranche) have in many cases seen radically diminished volume and profitability, or been completely subsumed by electronicization, such as the complete ouster of open-outcry floor brokers on the French futures exchange MATIF during a two-week period in 1998 after the exchange began offering parallel electronic contracts, which took almost all volume from the open-outcry pits (the brokers even went on strike in protest). 

 

Some exchanges, such as the CME and the CBOT, have managed to retain open outcry alongside growing electronic trading operations.  But, electronicization seems to be the future of trading of most standardized financial products, such as exchange-traded bonds, equities, futures, and options, where terms of the instrument are transparent and the only variables are price and volume, and total anonymity is acceptable to end participants because trade settlement is regulated and straightforward, and is the responsibility of the exchanges and broker-dealers.

 

However, two qualities, lack of standardization and lack of liquidity, make electronicization difficult for some financial instruments.  Most importantly, customized instruments are difficult to trade electronically; hybrid systems of voice brokers using electronic back-end trade settlement systems seem to be the most practical market for these.  Secondarily, even standardized instruments without readily available pools of liquidity, such as distressed debt and convertible bonds, have remained non-electronic to date. 

 

 

Inter-dealer brokers are a small club of specialized brokers who act as an intermediary between institutional participants in wholesale financial markets, for complex and/or large transactions in equity and credit derivatives, fixed income, money market, foreign exchange, and energy.  They operate primarily in the “over-the-counter” market for these products (i.e instruments not traded on an exchange).  The biggest interdealer brokers by market share are Icap (25%), Tullett (18%), Tradition (14%), BGC/Cantor (14%), GFI (11%), E-Speed/Cantor (2%).

These OTC wholesale markets are growing rapidly, as the instruments traded are used to manage and profit from volatility in interest rates, equity and debt markets, commodities and energy, which have all become much more actively traded markets due to proprietary trading from investment banks and hedge funds.  Also, market volatility creates more demand for the products that TLPR  trades.

The inter-dealer brokerage business qualifies as a “good business” in that while the sector is fiercely competitive, there are a limited and shrinking number of participants, and returns on equity are high, as the company acts as a middleman and there is no real cost of inventory.  The marketplace of complex financial products has been expanding for years as new products are being invented and become mainstream (swaps, CDOs, CDSs, etc.), thus allowing the transfer of risk between participants in the financial system (especially from regulated entities such as commercial banks that wish to diminish risk, to unregulated entities such as hedge funds that trade risk) and seems unlikely to stop growing.

However, products traded by the interdealer brokers tend to follow a lifecycle which requires the entrance of new products to sustain revenue (eg commissions on existing products decline every year on average):

 

-- New, high-commission, low-volume products are introduced, which are traded by open-outcry voice

-- As products mature, volume and liquidity increases, and commissions decline, and the products begin to move to semi-electronic platforms

-- Fully mature products become commoditized and electronicized (US treasuries, spot FX)

-- But, many products remain too complicated to trade on an electronic platform

 

The OTC derivatives market has grown at a very high rate in recent years.  According to ISDA’s market survey, this is the growth in notional amounts (in billions of USD) outstanding at year-end for the last five years for the following categories:  total interest rate and currency swaps and interest rate options (IR+FX), credit default swaps (CDS), and equity-linked derivatives:

 

Likewise, the Bank for International Settlements reported that notional amounts outstanding of credit default swaps grew 42% in 2006, to a total of USD28.8 trillion.   Detailed breakdowns are available here:

 

http://www.bis.org/statistics/derdetailed.htm

 

 

Tullett’s revenues should increase by at least 100mm beyond organic growth in 2007 due to the January acquisition of Chapdelaine, a smaller fixed-income specialist broker.  Chapdelaine’s margins are presently lower than TLPR’s but TLPR predicts that they will be able to bring them up to TLPR’s margins this year.

 

 

 

By comparison, Tullett’s two main publicly-traded competitors, GFI (GFIG:Nasdaq), and Icap (IAP_LN) trade at higher forward multiples:

 

2007 estimates:

 

                        P/E                  TEV/Revenue            

GFI                 24.0x                     2.3x
Icap                 17.1x                     2.6x

 

Publicly traded equity and derivatives exchanges, also potential acquirers of TLPR, trade at even higher forward multiples, making an acquisition of Tullett very accretive to them:

 

2007 estimates:                                  

                                                                        P/E

NYSE Euronext (NYX)                                 31.2x

Nasdaq (NDAQ)                                            24.7x

Chicago Mercantile Exchange (CME)            37.3x

Chicago Board of Trade (BOT)                      42.7x

InterContinental Exchange (ICE)                   46.4x

International Securities Exchange (ISE)         36.6x

 

The inter-dealer broker sector is undergoing rapid change and consolidation, with TLPR having been a buyout target in the last two years, and having itself made a $12/share bid for US electronic rival E-Speed (ESPD) recently (that bid is highly unlikely to succeed as ESPD’s controlling shareholder, BGC Partners/Cantor Fitzgerald, has said it will not sell, and in fact BGC Partners has cancelled its planned IPO and instead is doing a reverse merger into ESPD, valuing ESPD at $9.75/share).  

 

TLPR has been approached in the last two years by several financial buyers: PE firms Hellman & Friedman (a large shareholder in the NASDAQ), Blackstone and KKR.  The firms have been unable to agree on price with TLPR.

 

Merging with another interdealer broker would make sense, but the interdealer brokers have been fierce rivals at a business and personal level, with the relations being characterized in the UK press as “Business rivals who trade punches as well as bonds”:

 

“It is hard to find a feud as deep and vituperative as that between three of the wealthiest men in the City: Terry Smith, Howard Lutnick, the head of Cantor Fitzgerald, and Michael Spencer, the chief of Icap, another interdealer broker”  Times of London, “Broker Feud Deepens over E-Speed Bid,” April 19 2007.

 

However, it is also believed in the interdealer industry that despite the personal feuds, mergers between the competitors are possible as long as the buyout price for the target is high enough. 

 

The interdealer broker businesses are also logical tie-ups with the equity and derivatives exchanges, with the Wall Street Journal reporting in September that the “merger trend sweeping big exchanges is cascading toward interdealer brokers,” and discussing talks between Icap and the London Stock Exchange, and E-Speed and the CBOT.   The UK press also reported in February that Tullett Prebon has recently “held informal talks with the CME, Nasdaq, Deutsche Borse and Euronext” and that Smith “is by no means committed to independence.”  Sunday Observer, “Terry Smith ponders stock exchange tie-up,” Feb 18 2007.  Smith just last week wrote an op-ed in the Financial Times complaining about the headaches and distractions of having public shareholders.

 

Risks

The risks to the core business are much faster electronicization than we anticipate; a slowdown in derivatives trading volume either due to regulation (unlikely) or some long-term slowdown in the securities business, such as a shift in capital away from hedge funds and prop desks at investment banks (not inconceivable but also seems unlikely); or a derivatives risk control/settlement failure specific to Tullett or a major counterparty, as Warren Buffett and Charlie Munger regularly warn.  Tullett had GBP12.5bb in outstanding customer trades at year-end, so like all broker-dealers they face significant risk from a major settlement/counterparty failure.  However, the NY Fed in 2006 forced dealers to clean up a large derivatives settlement backlog and introduce an electronic settlement system, so settlement risk should be somewhat diminished.  

 

A key part of our valuation thesis is that TLPR will continue to return a large portion of its free cashflow to investors.  If pressure from electronic markets requires TLPR to begin reinvesting substantial amounts of free cashflow into improving electronic systems, then our valuation risks being somewhat high if the market perceives those investments as unproductive or merely revenue-maintaining.

 

Tullett has guided that 2007 revenue will be hurt by the strength of the pound, and expects 2007 revenue to be backloaded into the second half, so there is execution risk to the 2007 estimates above.

 

Also, as in any business where the “main assets ride the elevators down every night”, TLPR is vulnerable to poaching of its brokers by competitors, although that seems to be a largely low-level skirmish that has been ongoing in the business for decades.  However, losses can sometimes be significant -- TLPR lost more than 50 brokers in Hong Kong and Singapore in 2005 to BGC, which has led to extensive litigation by TLPR against BGC.  That size of a move may have been unusual, as BGC was a new entrant to the market and also took 32 brokers from Icap in Hong Kong.

Value-enhancing moves by CEO/controlling shareholder; acquisition by competitor, exchange or bank; Toscafund (UK activist hedge fund involved in ABN Amro takeover) is a 13% holder.   Recent activist targets in this general space include ESPD and Investment Technology Group (ITG), where DE Shaw has demanded a recapitalization or sale.

Major recent events in the equity and derivative exchanges and broker/dealer sector: 

May 22, 2006: NYSE Group, parent of the New York Stock Exchange, said it was buying Euronext for $14.3 billion. The deal closed later in 2006, with NYSE defeating a rival bid from Deutsche Boerse.

Sept. 1, 2006: Intercontinental Exchange Inc., a mostly electronic-trading market owned by major Wall Street brokers, announced a plan to buy New York Board of Trade for $1.1 billion, a deal that closed earlier this year.

Oct. 17, 2006: Chicago Mercantile Exchange Holdings announced a bid for its longtime rival, the Chicago Board of Trade, worth $8.8 billion.

Feb. 1, 2007: NYSE Group and the Tokyo Stock Exchange agreed to an alliance in technology and marketing but no cross-shareholdings.

Feb. 10, 2007: Nasdaq Stock Market's bid for London Stock Exchange, worth about $3.7 billion, failed.

Feb. 23, 2007: London Stock Exchange and the Tokyo Stock Exchange agreed to explore ways to cooperate, including operating a market for growth companies. No cross-shareholdings were involved.

March 15, 2007: Intercontinental Exchange (ICE) launched a surprise $9.9 billion stock bid for CBOT Holdings, designed to break up that company's planned merger with Chicago Mercantile Exchange Holdings.

April 18, 2007: Tullett acknowledges it has bid $12/share for ESPD; bid rejected on following day by BGC Partners/Cantor Fitzgerald

May 1, 2007: Deutsche Bourse agrees to buy International Stock Exchange (ISE, a new US options exchange) for $2.8 billion.

May 21, 2007: NYSE CFO states that ICE has put itself “in play” by bidding for the CBOT.

May 30, 2007: BGC Partners cancels its IPO, announces merger into eSpeed which values eSpeed at $9.75/share (ESPD now trading around $9/share)