Description
Just in time to honor of the 400th anniversary of the charter of the Dutch East India company, Van der Moolen is an ADR that promises to remake the mental financial image of the Dutch from peddlers of overpriced tulips to profitable traders of financial instruments.
At the very least, you’ll know the difference between a Pokemon (fantasy, evolved cross-breeds of different animals) and a Hoekman (the Dutch term for specialist).
--Let’s Go Dutch!
According to the company, Van der Moolen is an “international trading firm active in equities, bonds and related instruments.” That is true, but the great majority of the company’s revenues and profits are derived from being a top specialist on the NYSE. And indeed, it’s the NYSE specialist division that is the true “tulip” among lesser garden-variety flowers and in the case of its Cohen, Duffy option business, weeds.
Reduced to a single sentence, VDM is a compelling investment because you’re buying a business with a symbiotic relationship with a decent long-term ‘moat’ – the New York Stock Exchange. VDM is available at a modest price because of a bear market in listed stocks that has temporarily eaten away at the revenue-drivers of the business, American and European stock markets caught in ‘the fog war’ (lackluster trading volume), temporary reductions in intra-day volume in its largest specialist assignment, Pfizer, and lastly, a wave of selling in European stock markets that has especially driven down the price of stocks based in Amsterdam.
--The Power of the NYSE
It’s difficult to understate how much larger and more significant the NYSE is over its American and world-wide rivals. The market capitalization of NYSE stocks is more than all the companies trading on other stock markets COMBINED.
LaBranche (LAB), the largest NYSE specialist, published a nice chart last year that really crystallizes that fact: as of August 2002, the NYSE was over 6x bigger than Toyko and 10x bigger than NASDAQ and London
Truth be told, the NYSE is still the place to list – or move to, as continued migrations of NASDAQ firms to the NYSE in past years demonstrate. In 2001, there were 26 transfers from NADSAQ to NYSE, in 2002 36 transfers (currently there are more than 2500 common stocks listed in the NYSE). The number of transfers in any given year is less important, in my opinion, than the continuation of the pattern: small companies transitioning from NASDAQ to NYSE; large international corporation also using ADRs to gain access to NYSE liquidity (over 350 foreign companies have NYSE listings).
Why is the NYSE so attractive? And how can the “old-fashioned human-based” NYSE compete with the “faster, electronic” markets like NASDAQ and even more nimble ECNs?
Quite well, actually.
There are two common misperceptions about the NYSE: first of all, that it is a ‘human’ market. This is only partially true. The NYSE is in fact a hybrid marketplace, as its electronic SuperDot system demonstrates. The NYSE SuperDot is actually the world’s largest ECN; over 92% of orders and 76% of volume is routed through the electronic SuperDot. The result is that the NYSE is able to offer both fast executions and a depth of liquidity that ECNs that cannot match. In fact, LaBranche has stated that it sees ECNs such as Instinet as a source of business rather than a direct competitor.
Also noteworthy is that the NYSE specialists have been able to maintain a high share percentage – despite an “open book” and revocation of an old NYSE rule that made it difficult for ECNs to trade NYSE stocks. NYSE specialist market share of listed stock trades has ranged between 81.9-84% over the past five years. Indeed, it’s the unusually high number of stocks below $5 that has caused the market share of NYSE specialist to drop to over 2% to 81.9% in 2002 (less intra-day dollar volatility means less need for NYSE specialist services).
Why won’t the NYSE eliminate the “specialist” function, such as other markets (such as the Amsterdam Stock Exchange)? Because there’s no good reason to do so – the NYSE, in its hybrid form, is already more than competitive with NASDAQ and ECNs. The NYSE offers competitive execution times, better depth of liquidity, and less volatility that NASDAQ. Furthermore, consider the 27 members of the NYSE Board of Directors: Robert Murphy of LaBranche (the top specialist firm) is a Vice Chairman of the NYSE, Joseph Mahoney of Bear Wagner (another specialist firm), Henry Paulson Jr. of Goldman Sachs (which owns Spear, Leeds, and Kellogg – the second largest NYSE specialist), Christopher C. Quick of Fleet Specialist (which is the third largest specialist firm).
Clearly, there are a lot of people who have a vested interest in the continuation of the NYSE specialist system.
In addition, it’s easy to measure the strength of the NYSE – so that a VDM investor will not be blindsided by a sudden blow to the exchange. Is market share holding up? Are listings continuing to migrate from the NASDAQ to the NYSE? Is NASDAQ’s SuperMontage gaining ground (SuperMontage is NASDAQ’s attempt to bring together fragmented order books into a single open book – an advantage the NYSE already have)?
In some sense, the NYSE is the E-Bay of the financial world. If you are interested in listing a stock (or a trinket for sale) you want to head to the market with the best liquidity (potential customer base) and greatest visibility. And liquidity and listings attracts more liquidity and listings – there are clear network effects in play at the NYSE.
--1997 Changed Everything
35 years ago there were 150 specialists firms on the NYSE. In 1997 there were 38 specialists firm, and now there the NYSE is down to seven. What happened?
Three factors drove this consolidation. The dramatic rise in NYSE dollar volume over decades drove home the need for specialist firms to have substantial capital resources. Secondly, trading costs keep going down. Lastly, in 1997 the NYSE changed allowed companies to choose their specialist directly rather than being assigned a specialist by an Allocation Committee. Previously, if there were 38 specialist firms, each specialist firm had about 1/38th opportunity to obtain a new listing. Of course, the committee was supposed to take into account the needs and abilities of the listing company and the specialist firms, but in reality the tasty treats were divided kindergarten style (everyone treated about equally).
Now all potential NYSE listings choose their own specialist firm directly, and the capabilities of the NYSE specialist firm – depth of capital, willingness to commit that capital, marketing prowess, etc – have forced consolidation among NYSE specialists (usually partnerships and family-owned businesses) as issues of scales matter so much more.
There are now 7 firms and the top 5 firms account for over 95% of the dollar volume traded. LaBranche (LAB) and Van der Moolen (VDM) are the only two publically traded pure specialists (although other specialists such as Spear, Leeds, and Kellogg (SLK) are part of publically traded entities such as Goldman Sachs).
--Paid to Provide Liquidity
Van der Moolen has achieved a 10% dollar volume market share and 15% listing market share by participating in that extensive consolidation.
As presently constructed, Van der Moolen receives about 80-90% of annual revenue from their NYSE specialist functions. So although the company reports in Euros, there’s a “natural hedge” for USA-based investors because so much of their revenue is dollar-based (and Euro-denominated debts are quite manageable).
As a NYSE specialist, VDM acts as a “auctioneer” between buyer and seller. However, commissions are a miniscule part of the business. In 2002, commissions added up to less than 12% of revenue. The real action is VDM’s role as principal.
A unique and special obligation of the NYSE specialist is the responsibility to sell AGAINST market trends – to reduce volatility. Basically, in a rising market VDM sells stock from its own inventory and in a declining market purchases stock. Of course, there are lots of restrictions; VDM can’t buy and sell indiscrimately. Its trading is limited to the responsibility of being a primary liquidity supplier for a stock. And the average holding period is measured in minutes rather the than days, months, and years that value investors hold positions.
Nonetheless, guess who’s smart money and who’s dumb money? In 2002, 96% of trading days generated positive (profitable) results, and similar number occur for previous years.
Key factors that drive VDM specialist trading: trading dollar volume on the NYSE, VDM’s share of that trading volume; VDM’s ability to act as counter-party to that trading volume, and its realization rate on its trading.
This is a low margin, high volume business. Market direction has no impact on VDM profits in the short-term, although a lower market decreases the intra-day volatility – in absolute dollar terms – and pressures the realization rate.
Here’s how it worked out in 2002:
Total value of trading on the NYSE ($billions): $10,311
Percent of NYSE dollar trading that are VDM assignments: 10.0%
Value of trading in VDM specialist assignments ($billions): $1,036
VDM participation rate (VDM takes the other side of transaction): 34.6%
VDM value of principal shares traded ($billions): $358
Realization rate on principal shares traded (basis points): 5.9
VDM specialist net gain on principal transactions ($millions): $210.6
Basically, higher volatility (use the VIX index as a proxy) and greater volume leads to more opportunities for VDM to trade as principal and better realization rates. The bear market has hit the realization rate hard; VDM’s realization rate has declined from 8.1 in 2000 to 7.0 in 2001 and lower in 2002.
That’s also an opportunity, as any improvement in the market will flow down to a higher realization rate.
Still, the bear market has punished the bottom line of VDM. Cash earnings fell from EUR 106 million in 2001 (2.76 per diluted share) to EUR 79.4 million in 2002 (2.06 per diluted share).
What about the cost side? Another positive aspect of this business is that free cash flow basically equals or exceeds net income. In 2002 (Dutch GAAP), VDM invested less than EUR 10 million in tangible fixed and tangible financial assets in 2001 and 2002 combined. Depreciation exceeds those amounts.
If you’re looking for a business with little needs for marginal investments in fixed assets and levered to a stock market bounce, this is it.
--The Good, The Bad, and The Ugly
Let’s start off with the Ugly. VDM took a substantial writeoff (lots of goodwill) for its Cohen, Duffy options business in the 4th quarter of 2002. Frankly, the option business has been a real stinker. Negative revenues combined with substantial losses (EUR 17 million in 2002, EUR 20 million in 2001) make for a strong case of financial indigestion. But even a stinker runs out of stink – the US Option business broke even in 4Q/02 and is being restructured. This has paid off nicely, as over EUR 100 million in working capital has been freed up and the risk profile has improved dramatically.
It’s funny that the writeoff has finally taken place when the business has stopped bleeding profusely.
Now for the Bad. VDM reported disappointing Q1/03 results. EUR 6.0 million (excluding one time gain). This is over a 60% drop from 4Q/02 results and from Q1/02 results. Why did results drop so dramatically from the Q1/02? Lower principal trading revenues: a 8% drop in participation rates (31.7 bps versus 34.9) and a 29% drop in realization rates (4.2 bps versus 5.9 bps).
This is actually better than what VDM suggested in their Q4/02 conference call.
In March, VDM announced that the first quarter of 2003 was looking god-awful. January and February generated only EUR 3 million profit combined. In January and February VDM reported a negative 19% year over year drop in dollar volume; a negative 25% drop in the realization rate to approximately 4.3 basis points due to the lack of retail and institutional participation in the market; a negative 10% drop in the participation rate from 34% to 30% due to the higher percentage of program trading that generating ‘poor quality volatility’.
Fortunately, almost every trading day was profitable in Q1/03, just so much less so.
Ready for the Good? All of the above are temporary or fixable problems. The US Options business can be restructured or shut down, and has stopped bleeding. The ‘fog of war’ will be lifted, and the historic growth in NYSE trading volume will continue. (Interestingly, the largest customer of the NYSE is the CBOT, as investors utilize the cash market to hedge their derivative instruments).
Even if the market recovers slightly (or holds onto its March 2003 gains), VDM should be able to generate the type of profits it has in the 4th quarter of 2002. If so, that would be about EUR 18 million and cash earnings of EUR 0.48 per common share. If VDM can generate 1.40-1.50 per share cash earnings per share (basically free cash flow), that would be a 7.5 p/fcf ratio on a depressed revenue stream. Consider the upside potential – VDM made 2.76 in cash earnings in 2001 and more in 2000. Even a modest rebound to 2001 levels (with a breakeven US Options business) should generate a pop in VDM’s stock price.
VDM is also taking steps to return cash to shareholders. VDM has a policy of issuing 40% of earnings as dividends. In mid-April, VDM shareholders received a EUR 0.72 per share dividend - to be paid out in early May - (based on 2002 earnings). That was better than a 7% cash yield. The company is also hedging its exposure to euro depreciation in 2003, and has committed to buying back up to 6% of its shares. Unfortunately, my original application to VIC was made before the stock went ex-dividend, but did not process until now. So VIC readers won't be able to receive the dividend.
Still, the best part is the fundamental attraction of the business model. A low margin, high volume business with a degree of moat and with little demand for marginal investment (except for acquisitions or expansion). Van der Moolen has the assignments for Pfizer, Hewlett Packard, International Paper, Eli Lilly, and other companies. Unless those companies are acquired (VDM lost the Time Warner assignment after AOL purchased it), you’re going to benefit as 80% of transactions in those fine blue chip stocks go through VDM’s computers and hands.
Catalyst
-Improvement in US stock markets leading to additional trading volume and higher realization rates
-Potential acquisition target from larger owners of specialist firms (LaBranche, Fleet, or Goldman).
-Cost cuts and stabilization of US Options business.
-Turnaround in European stock markets leading to short-term stock price pop.