Several years ago I read a bullish article on TMX Group Inc. (OTC:TMXGF), Canada’s main stock exchange. It said TMX had a “monopoly” on stock trading, a veritable license to print money. The reasoning was persuasive and the writer had the chartered financial analyst designation, so I skipped all that due-diligence stuff and bought some shares.
Shortly after, of course, alternative trading systems cropped up and TMX’s moat sprang a gusher. Its shares tumbled into a crater deeper than the one named after Michael Jackson.
In recent months I have been trying to address the state of neglect in my portfolio and looked into, among other things, whether I should dump March Networks (OTC:MNTWF) or add Manulife Financial (MFC). As part of that process, I finally got around to doing some due diligence on TMX. Here’s a condensed version of the analysis I did (and wrote up in a piece for GlobeInvestor GOLD).
There has been a lot of negative sentiment surrounding TMX — especially related to the emergence of Alpha Group, the alternative trading exchange launched by the chartered banks. But a cyclical upturn appears to be getting underway in TMX’s diversified business lines; with expectations dampened by the specter of competition, the odds for some positive earnings surprises in quarters ahead would seem to be improving.
Not to be overlooked is the dividend, currently yielding 4.7 per cent. It is well supported: during the first nine months of 2010, the company paid $84.5 million in dividends and earned $147.5 million in net income, for a payout ratio of 57 per cent. The dividend looks even more solid on a cash-flow basis: the $203.7-million cash earned from operations over the past nine months translates into a payout ratio of 41 per cent.
Dividend increases had been frequent and hefty after the initial listing of shares in 2003, up to 2008. Then there were no increases for two years. That drought ended this week, with the announcement of a two-cent increase in the quarterly dividend to $0.40. This 5-per-cent hike is a sign that TMX is confident about the future, CEO Thomas Kloet said at a news conference.
Share of stock trading may be stabilizing
What may help stem declining market share for TMX in stock trading is a regulatory investigation into conflicts of interest at Alpha Group. There are concerns the banks’ brokerages have incentives to funnel client orders to the exchange without regard for best execution. Indeed, BMO Nesbitt Burns recently paid a fine to regulators on this count.
TMX’s market share of stock trading in Canada had fallen to 70 per cent by the summer of 2010 but rebounded to 75 per cent in September. GMP Capital analyst Stephen Boland believes regulatory chill has curtailed some practices at Alpha and TMX is benefiting as a result.
In response to rising competition on the equities trading front, TMX is pursuing a strategy of diversifying revenues. To date, it has branched out into derivatives, options, natural gas/electricity contracts, fixed-income securities, market data and other fields. “We remain committed to exploring opportunities for growth whether they’re organic, or in other ways such as acquisitions, investments, partnerships or business combinations,” said Mr. Kloet during a conference call with analysts.
One main growth opportunity lies in responding to calls to improve over-the-counter derivatives trading by setting up exchanges or clearing houses. “The big growth in the securities business generally, and from the TMX, specifically, is going to be in the derivatives area,” Caldwell Investment Management Ltd. CEO Brendan Caldwell told Reuters.
Cyclical pick-up in business
We’ve been through a severe recession, central banks have responded with a wave of monetary stimulus and stock markets are regaining upward momentum. The sweet spot for transactions-based companies like TMX would seem to be here.
Financial results for the third quarter were released Oct 27. Compared to the same quarter last year, revenues rose 8 per cent to $141.6 million, earnings per share climbed 21 per cent to $0.68, and cash flow from operating activities jumped 56 per cent to $58.3 million. These results were above analysts expectations.
“We were able to achieve overall revenue growth while delivering fee reductions for many of our customers,” noted TMX’s chief financial officer, Michael Ptasznik. And the entire revenue increase flowed through to the bottom line thanks to a two-percent drop in expenses, “primarily as a result of our move to a more efficient technology platform.”
Compared to the third quarter in 2009, there were gains of 14 per cent in listing fees (to $40.5 million), 3 per cent in revenues trading stocks, derivatives and energy contracts (to $58 million), and 8 per cent in market-data services (to $38.8 million).
Takeover bid for sister exchange
A takeover bid was launched in October for Australia’s main stock exchange by the Singapore Exchange (where Mr. Kloet was previously the chief executive) at a valuation nearly double the one attached to TMX. The Financial Times of London commented: “The deal is widely seen as a harbinger of accelerating consolidation among markets around the world.”
Disclosure: I currently hold shares in TMX Group.