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Competitive Advantages

NASDAQ OMX Group, Inc. (NDAQ) as an entire company generates high returns. In 2011 its after-tax operating margin was 26.45%; approximately $700 million in operating income on approximately $1.7 billion in revenue is quite impressive. From 2005 to 2011 NDAQ's net income margin was 24% compared to the average profit margin for the technology sector of 9.38% and Business Software & Services industry of 9.9% according to Yahoo! Finance. Returns on assets and on invested capital don't seem impressive initially, but if one ignores the clearing contracts and the intangible assets (and there are good reasons to do so) they are quite high at 32% and 68% respectively. These returns are indicative of the industry of financial exchanges right now: its most direct competitor, NYSE Euronext, had an operating margin slightly above 30% for 2010-11.

The core operating segment of NDAQ is market services. The primary driver for Market Services is the volume of transactions it matches. Matching is exactly what it sounds like, matching a buy order and a sell order for an equity or derivative, for which they charge a very small fee per share or contract traded (on the order of 1/10 of a penny). NDAQ includes Access Services in its calculations for Transaction Services, I think it makes sense to break that out separately, so when I refer to Transaction Services it is the entirety of NDAQ's equity and derivative matching services. Transaction services, which consists of matching and routing orders to other exchanges or brokerage groups for them to match, accounted for 37% of the Market Services after tax net income in 2011. That is equivalent to 30% of NDAQ's entire net income for 2011. The other two parts of Market Services include Access Services and Global Data. Even though together these accounted for 50% of NDAQ's 2011 income (20% more than transaction services), their success directly depends upon the existence and robustness of NDAQ's transaction services.

Access Services includes broker and exchange member fee revenues and another category of revenues from premium options for clients to access their exchanges with less latency for the quickest execution times for orders, an example of which is co-location services. Global Data consists of revenues from firms that buy quote data from NDAQ directly. Products include NASDAQ Basic which provides level 1 data (lowest ask and highest bid in the market) and NASDAQ TotalView which provides level 2 data (level 1 + market depth info) as well as several other products of particular utility to high-frequency trading clients. What should be very clear is that NDAQ can only provide real value in these services to their clients if they remain a major center of market-making: matching and routing trades.

If they don't, the demand for access services will evaporate and their current advantages in data services would disappear. Currently, they can provide the information for everything taking place on their exchanges quicker and more cheaply than third party data providers like Thomson Reuters or Bloomberg who receive the data from regulated data distribution plans (in America, the UTP plan). The more matching and routing that occurs over NDAQ exchanges, the more valuable their data products are. Thus we need to understand whether there are real competitive advantages for NDAQ's transaction services. If there are then these naturally extend to Access Service and Global Data; if there are none, then these segments probably have none as well.

NDAQ's Market Services have had an average pre-tax operating margin of 44% for the 3 years 2009-2011. After tax figures are broken down further on a year by year basis so they will be used (See Sum of The Parts Valuation slide in NDAQ's 2012 Analyst Day presentation). For 2011 Market Services had an after-tax operating margin of 32%. Transaction Services in 2011 had a margin of 24%. The highest return comes from Global Data with an after tax operating margin of 48%. These returns suggest that competitive advantages exist. However if one looks at the situation from the perspective of market share, it is easily gleaned that this industry is not stable and there is little to nothing firms can do to protect market share.

Competitive advantages that used to exist, such as the economy of scale the trading floor of the NYSE had before the advent of the internet, have been eroded by technology. It is an extremely scalable business with high fixed costs. Once these costs are sunk, the cost for matching an additional thousand orders is practically nothing.

If incumbent market leaders were able to sustain their market shares it would be very good evidence for the presence of competitive advantages. Market share has not remained stable though; it has swung wildly for NDAQ and its strongest competitors.

In 2007 NDAQ matched 46% of all the volume in NASDAQ listed securities; in 2011 it matched only 31%. The NYSE matched 79% of all the volume in NYSE listed securities in 2005. In 2011 it only matched 35%. In absolute terms, the NYSE matches less volume today than it did in 2005 despite a doubling in total market volume for NYSE listed securities.

BATS Trading was able to buy a sustained 7% of the market share in matching volume for NASDAQ listed securities by operating at a loss that came to $5 million for one month. Before that "promotion" BATS had less than 3%, their share spiked to 15%, and dropped back to around 10% in January of 2007. They used this tactic again for NYSE listed securities. What this demonstrates is that transaction services is a commodity industry with no customer captivity, no high search or switching costs, and no entrenched habits. The founder of BATS stated at one point that he wanted to run exchanges like utilities and dislikes the NDAQ NYX regime of profit seeking and high returns. This does not engender a culture of competitors open to cooperation on price setting.

Talented engineers and programmers and the ever more accessible costs for hardware and server space have made setting up an Alternative Trading System (ATS (or MTF in Europe)) an accessible venture for any individual or business so inclined. BATS was able to get capital in 2007 to get its operations rolling from clients of NDAQ and the NYSE like Morgan Stanley, Credit Suisse, Lime Brokerage, and Merrill Lynch. This demonstrates a uniquely high demand for more competition (perhaps it isn't so unique but, content customers, in my mind, are not customers who fund ventures to compete with their current service providers). Investment Banks like Nomura and UBS have actually launched MTFs out of the infrastructure of their internal order books, and Goldman has announced its intention to do so. Regulation has also helped erode advantages by regulating the distribution of market data.

The high returns NDAQ sees today in this segment are the product of an industry that is just starting to become competitive across the US and Europe and across both equities and derivatives. A perfect example is NDAQ's NASDAQ OMX Baltic & Nordic Exchanges. In 2007 volume in securities listed on these exchanges was executed exclusively by NDAQ: 100% market share. By 2011, these markets had opened up to some competition and NDAQ's share is down to 71%. I see nothing NDAQ can do to prevent this share from sliding down to 30%-40% range over the next 5 years if not sooner, in the same way NYSE share of volume in NYSE listed securities fell. Their data products will stay high margin but if only a trivial amount of market making activity occurs through NDAQ then the discount clients can receive by obtaining that data directly from NDAQ becomes less relevant.

The expanding number of entrants into this industry winning market share away from incumbents spells out the verdict that NDAQ's core business is without sustainable competitive advantages and time will wither away its high returns in a commodity service.

Competitive advantages do exist in NDAQ's other segments, they just don't happen to be very material to NDAQ's overall results. In issuer services it is clear that listing services has major competitive advantages. In the US NASDAQ represents the only viable competitor to the NYSE. In the Nordic and Baltic regions, NDAQ is really the only viable choice for regional companies. Listing services had a 2011 operating margin of 16.7% and contributed 12% to total income. While this is significant, there are no indications it will be a driver of growth going forward and will therefore probably remain an afterthought to market services. The other part of issuer services is the Global Index Group which has great margins at 29% after tax, but its 5% contribution to earnings means that even if it has significant competitive advantages they do not substantially contribute to NDAQ's competitiveness as a whole.

Market Technology has the lowest operating margin of any of NDAQ's operating segments at 9% over the 3 year period of 2009-2011 but it arguably has the largest competitive advantages among them all with the exception of listing services. It has 10% of the global market share: 1 out of every 10 securities transactions takes place through NDAQ's market technology. Customer captivity is significant: NDAQ creates highly customized market technology for each customer with average contract lengths of 5 years. I do not think the returns generated in this segment will be subject to competitive aggression on any level near what NDAQ's market services segment will face. Market Technology only contributed 4% of NDAQ's 2011 after tax income.

NDAQ's core business will see an erosion of returns over the next decade as evidenced by large swings in market share and current operating margins exceeding 20%. The large swings in market share demonstrate the inability of NDAQ to prevent competitors from taking their business and the high operating margins demonstrate the potential for returns to be driven down significantly as the industry becomes more competitive.

Future Earnings

It follows from the discussion of NDAQ's competitive advantages that by certain metrics NDAQ's earnings will drop over the course of the next decade. It is rational to assume operating margin will fall as transaction services across the world become more competitive, driving returns down to the cost of capital. Revenues might continue to grow, though they just as easily might not. The average six year growth rate for revenue is 24% but that is primarily a product of boom years 2006-2008 as well as the merger of NASDAQ and OMX AB. The last three years have seen a much more modest 5% growth.

How has NASDAQ grown in the past? Acquisitions since 2007 have included: Thomson Reuters Corporate Services, SMARTS Group, Director's Desk, NOS Clearing ASA, Boston Stock Exchange, Philadelphia Stock Exchange, Shareholder.com, GlobeNewswire, OMX AB, FTEN, BWise, RapiData, and more. Part of this is an effort to keep NDAQ competitive in its current businesses; some are expanding into new business lines. It might be the case management realizes that the returns they see today will not be around forever and diversifying into other less competitive businesses might be the best way to prepare.

Organic revenue growth does not look promising and operating margins are to be decreasing in NDAQ's core business, therefore future earnings are probably going to be no greater than they are today. NDAQ might be able to acquire more business, become more efficient, and enter more markets as competitors enter theirs and therefore keep earnings the same to marginally growing. But that is a lot to ask and acquisitions do not always work out so well as their foray into insurance with Carpenter Moore demonstrated. Anti-trust concerns have made it clear that NDAQ cannot merge with another large equity exchange and even if major consolidation took place it is not clear how this could protect NDAQ's high returns.

Absolute market volume has gone down in the past couple of years and even if it were to return and quadruple previous records it would attract more competition and drive prices further down towards the cost of capital. Servicing a trillion new equity or derivative transactions once the capacity is in place to service the first trillion is not prohibitive because electronic matching is so scalable.

NDAQ's main business faces serious headwinds over the mid-term and long-term time horizons, not with regards to their survival as a profitable company, but certainly regarding their high returns.

Valuation

With a stock priced, as of 1/11/2013, at $26.58 NDAQ has an earnings multiple of 11.32 based on 2011 earnings and 2012 earnings are looking to be grimmer: trailing 9 months income for 3Q 2012 lags 3Q 2011 by $40 million or 13%. Most of this decline is because of less market volume which demonstrates how central Transaction Services is to NDAQ.

Now I am not forecasting doom and gloom, just a slow decline. The only reason for NDAQ to absolutely tank would be some unprecedented lawsuit that for instance, holds Nasdaq liable for fraudulent Chinese listings. I think this is highly unlikely but crazier things happen.

In my view, NDAQ has a lot of tools for softening its decline. The company is trimming the fat, downsizing by offering incentives for early retirement, attempting to achieve substantial cost savings across its divisions, it has $87 million in deductible goodwill for tax purposes, $235 million in deferred revenue, and on top of that it can and tries to do its best to direct the public's attention to its growing segments, and talk revenues not earnings. On the 3rd Quarter 2012 conference call (the most recent) revenues were mentioned 49 times and revenues are what they break out for specific acquisitions and segments. Income was mentioned twice and so were earnings and all 4 times were only with regards to the entire company's results. On that same call management expectations are for margins to be steady to slightly increasing for all non-core businesses, but that transaction services' margin, which drowns out the others, is volume dependent. Maybe in the short-term that margin is volume dependent; in the long-term it is reliant upon an industry staying uncompetitive which seems very unlikely.

Some segments I expect will continue to grow: market technology & global indexing. Both of these segments will marginally contribute to global data.

Despite these bright spots my analysis has convinced me that NDAQ will fail to maintain earnings power even as revenues grow across noncore segments because Transaction Services faces so many headwinds. An 11x earnings multiple is not extreme and I think there are much better opportunities for short selling in the market, but I also don't think there is long term value for investors around its current price. Because I expect earnings to decline well into the future I wouldn't buy unless it got to the low-teens.

*ROIC was calculated as Operating Income/(Total Assets - Noninterest bearing liabilities) following the methodology Bruce Greenwald suggests in Competition Demystified.

Source: Nasdaq OMX Lacks Sustainable High Returns