Description

A company’s value is determined by its fundamentals, not its country of listing. For example, if we have two identical companies, one listed in the US and the other listed in Europe, and these companies are identical in every way except country of listing, then their fundamental value must be the same. Van der Moolen (VDM) and LaBranche (LAB) are both NYSE Specialists. They trade in the exact same building (100 Wall Street), on the same floor, with the same rules, regulated by the same people, trade for the same customers and compete for the same listings. The only meaningful difference between these two companies is that LaBranche is a NYSE listed company (with a high debt load), while Van der Moolen, by random history is listed in the Netherlands (with a US ADR under VDM). So why does the Dutch listed company trade at 0.8x liquidation value and 21x 2005E EPS while the US listed company trades at nearly 3x liquidation value and 29x this year’s earnings? Therefore, I’m recommending a pair trade long Van der Moolen (VDM) and short LaBranche (LAB). VDM shares should more than double in the bull scenario (as described below) and are awarded LAB’s valuation, if the bears are right (also described below), VDM shareholders should be well protected in the disaster scenario because shares already trade at 80% of liquidation value while in a disaster scenario LAB investors would find themselves with a 65% loss.

The NYSE Specialist business will undergo dramatic change in 2006 as the NYSE introduces its hybrid trading system, Reg NMS is implemented and electronic trading permeates the listed business. However, it appears the bulls are US based investors, pinning their hopes on Labranche and have driven the stock recently to a new 52-week high. Meanwhile, European investors have taken a much more skeptical view (maybe more skeptic because all their market are already electronic) pushing VDM shares not far from their all-time lows.

Market structure experts currently debate the fate of the NYSE specialists. The bulls argue that this change will be a boom for the business, volumes will explode with electronic trading and expenses will decline as the floor based human specialists are replaced with cheaper, faster computers. Thus the bulls contend, the specialists will enjoy unprecedented revenue growth while at the same time dramatically reducing their operating costs. On top of these dramatic margin improvements, the NYSE has proposed reduced capital requirements for the specialists as well so returns on capital will greatly expand. (Michale LaBranche, CEO of LaBranche is has very vocal supporting this outcome to investors and at conferences while Van der Moolen management has refrained from making such predictions, this could partially explain the run-up in LAB shares while VDM shares have been left behind).

On the other side of the debate, the bears contend that electronic trading will eliminate the need for specialists. Natural buy and sell orders will electronically interact without any specialist intervention as opposed to the current model in which a specialist much touch every order before it’s executed dramatically reducing if not eliminating the specialists opportunity for realize principal transaction gains. The commissions they receive for handling orders will be replaced by front end algorithms not involving the specialist. NYSE executives themselves have said they expect the 100 most active stocks to go completely electronic with no specialist intervention and LaBranche’s own 10Q disclosures report that approximately one-third of their revenue comes from their 25 most profitable stocks. Thus the bears contend that despite the fact that electronic trading will lead to higher volumes, the specialists revenues and profits will decline as they are disaggregated from the trading process.

The bull and bear cases are a hot debate (I tend to agree with the bears just for the record), but what isn’t a debate is that the outcome will be the same for all NYSE specialists and thus I argue that VDM and LAB should trade at similar valuation metrics reflecting similar levels of optimism/skepticism. However, this is not the case. Below are my estimated liquidation values for each company as well as other important valuation metrics.

Method 1

Converted to US$
Share Price VDM:$5.50, LAB:$10.25
Mkt Cap: VDM: $216m, LAB: $625m
LT Debt: VDM: $190m, LAB: $481m
EV: VDM: $406m, LAB: $1,106m

3Q05 EBITDA: VDM: $28.7m, LAB: $54.8m

EV/EBITDA: VDM: 14x, LAB 20x
EV/Net Revs: VDM: 3.2x, LAB 3.8x

Method 2 – Accounting for NYSE Seat Values and Reduced Capital Requirements

# of Seats: VDM: 10, LAB: 39
Value / Seat: $3.25m
Reduced Capital Requirements: VDM: $106m, LAB: $180m

New EV taking out seats and reduced capital
VDM: $268m, LAB $800
EV/EBITDA: VDM: 9x, LAB: 15x
EV/Rev: VDM: 2x, LAB: 2.8x

Method 3 Liquidation Value

GAAP Tangible Equity: VDM: $139m, LAB: $87m
Mark Seats to Market: VDM: +$32m, LAB: +$137m*
VDM Tax Due from Dutch Government: VDM: +108m**
Adj Tangible Book Value: VDM: $279m, LAB: $224m
Adj. Tangible BV/Share: VDM: $7.10, LAB: $3.67
Price / Liquidation Value: VDM: 0.77x, LAB: 2.79x


*VDM seats on books for $1.8m each while LAB seats on books for $1.5m each. Assumes NYSE distributes $450k per seat in cash and 80k shares of AX with market value of $57 per share.
**This is a receivable that is on VDM’s IFRS balance sheet, but not on its GAAP balance sheet. The company receives interest on this receivable.
***VDM is still receiving tax shields from amortization of intangibles which is not reflected in the above liquidation value. This would represent another $13m of value.

Catalyst

Reg NMS and Hybrid will both be implemented in 2006 and the outcome for the NYSE specialists will be determined. Whether this is a good or bad outcome, the certainty should reduce/eliminate the valuation gap between this two NYSE specialist firms.