Competition Hurting Toronto Stock Exchange

| About: TMX Group (TMXXF)

There was a time when TMX Group Inc. (TMXGF.PK) looked like a no-lose investment because it operated a no-lose business: the Toronto Stock Exchange. Investors certainly thought so, driving up the shares by 550% from 2002 until the stock’s peak in late 2007.

Since then, investors have had their doubts. The bear market, and its impact on trading and financing, dealt one blow to the stock. More importantly, alternative trading systems, such as Alpha Group and Chi-X Canada, have sprung up in recent years giving institutional traders an alternative venue and handing the Toronto Stock Exchange its first meaningful competition in more than 150 years.

Now, TMX shares have fallen back to their 2005 levels and the trailing price-to-earnings ratio is just 13, far below its average of 23. It’s cheap, but that’s only because there are some concerns surrounding the stock.

Doug Young, an analyst at TD Newcrest, raised his TMX Group earnings estimates for the third quarter, to 59 cents a share from 58 cents, to reflect better-than-expected financing activity in September. However he remained cautious on the stock, reiterating a “hold” recommendation and a 12-month target price of $35. The shares traded on Thursday afternoon at $35.30, up 1%.

“TMX offers an attractive dividend yield (currently 4.3%) and cash flow,” he said in a note. “However, valuation appears fair to us, we expect continued pressure on equity trading margins. We believe it has lost pricing power over its market data business and we fail to see a short term catalyst for the name.”

His thoughts on alternative trading systems were particularly interesting. Alpha’s share of the Canadian trading landscape has risen to 14.8% of non-block trading in September. That is up from 12.8% in August and 10.1% in July.

“At this rate, we wouldn’t be surprised to see Alpha hit the 20% mark by year-end,” Mr. Young said. “In contrast, the Toronto Stock Exchange’s share fell to 78.5% in September, down from 82.5% in August; reflecting lost share to both Alpha and Chi-X.”