When a company announces that it is being bought, usually that is the end of a stock's run, since there is nothing left to drive any meaningful upside. There may be an opportunity for some merger arbitrage, but that is it. However, NYSE Euronext (NYX) is presenting investors with a unique opportunity. The stock is, in our opinion, undervalued no matter what happens with the Deutsche Borse merger.
The reason behind NYSE's underperformance relative to the S&P 500 is simple: Deutsche Borse. Becuase NYSE shareholders are to receive Deutsche Borse stock in this deal, since February 2011, NYSE shares have been largely tied to the stock price of Deutsche Borse. And the German exchange has been battered as Germany and the rest of Europe attempt to work out the sovereign debt crisis.
Before we continue, we will outline the merger with Deutsche Borse. On February 15, 2011, NYSE Euronext and Deutsche Borse agreed to merge, creating the world's largest exchange company, with revenues of over $5.4 billion in 2010. Under the terms of the deal, NYSE stockholders will receive 0.47 shares of the combined company for every share of NYSE they own. NYSE CEO Duncan Niederauer will be CEO of the combined company, with Deutsche Borse CEO Reto Francioni serving as chairman.
Since Deutsche Borse shareholders receiving 1 share of the new company for each share they own, it is their share price that is the deciding factor for how much the combined company is worth. At the close of trading on Tuesday, January 3, Deutsche Borse was at 42.70 euros, or $55.67, based on the most recently available exchange rates. This values each share of NYSE Euronext at $26.16.
How can we recommend shares of NYSE Euronext at these levels when the merger agreement values the shares below where they are currently trading? We recommend shares for 2 reasons, and discuss 2 scenarios below:
- Successful closing of the merger. We think that at current levels, Deutsche Borse is itself undervalued, and therefore NYSE Euronext is as well. Deutsche Borse has been needlessly dragged down alongside European financials. Record volatility will benefit the company, and secular growth in the derivatives market will drive results.
Shares of Deutsche Borse have seemed to put in a bottom towards the end of 2011 as investors realize that both Germany and Deutsche Borse can withstand the debt crisis. The consensus price target for Deutsche Borse is 58.9 euros ($76.77). By extension, the consensus 12-month price target for NYSE Euronext is $36.08, representing upside of over 32% from current levels. If the merger is to in fact go through, however, we do not think Deutsche Borse will rise to 58.90 euros, since it will most likely close in the first half of 2012. But 2012 overall should be a much better year for the German exchange, and by extension, NYSE Euronext.
NYSE Euronext's stock price is also tied to the value of the euro relative to the dollar. The euro has fallen steadily in 2011 on the back of the European debt crisis, but 2012 should see a stabilization of the currency. We think that sooner or later, the ECB will give in and step into the markets to defend the continent. While quantitative easing usually weakens a currency, it is not always the case. The dollar has risen 13% since 2008 despite trillions in easing, and we think that the euro will rise as the ECB steps in.
We think global investors will see quantitative easing in Europe in a positive light, for it is a better alternative than a sovereign default or a country's exit from the euro, thus actually allowing the euro to rise, or at the very least, steady itself. Upon the closing of the merger, Deutsche Borse has pledged to pay a special dividend of 2 euros per share. This means that each share of NYSE Euronext will receive a dividend of $1.23 per share, for an immediate yield of 4.52%. Given that NYSE Euronext's annual yield is 4.41%, this dividend makes NYSE shares more appealing, and we do not think that it is being reflected in the current stock price.
- Merger breaks down. NYSE Euronext and Deutsche Borse recently agreed to extend the deadline for the merger to March 31, 2012, on the back of protracted opposition from the European Union, due to competition concerns. The most recent rumors are that the Competition Commission is prepared to block the merger. Given that Eurex and Liffe, Deutsche Borse's and NYSE Euronext's derivatives platforms, control almost all derivatives trading in Europe, scrutiny there has been far greater than in the US. Both companies have offered a variety of concessions, but both have said they will not divest Eurex or Liffe and would rather terminate the merger.
It is indeed possible to complete a merger over initial EU objections, as Oracle (ORCL) has shown. Even if the Competition Commission decides to initially block the deal, there is still a long road until it is certain that the merger will actually be blocked. The benefits of the merger have been clearly laid out, but we think that an end to the merger agreement could also be positive for NYSE Euronext. Terminating the merger agreement would allow NYSE Euronext to trade on its own fundamentals, free of its link to Deutsche Borse stock. NYSE Euronext will benefit from continued record volatility in both Europe and the United States, which should drive steady revenue gains.
The shares yield 4.41% on their own, which we think is a good match with continued growth in EPS and revenues, which have grown at a CAGR of 44.2% and 24.1% respectively over the last 5 years. NYSE trades at a price-to-book ratio of 1.02, based on a book value of $26.67 at the end of the third quarter. The company trades at just over 10x forward earnings and has a PEG ratio of 1.10, a huge discount to the sector average of 2.81.
NYSE Euronext is steadily growing and improving as a standalone business, something we think is currently being completely overlooked by the market. Leverage declined to 1.6x debt-to-EBITDA and should continue to decline in the fourth quarter and 2012. NYSE Euronext's technology services platforms are growing rapidly, and it is maintaining its leadership in listings. Technology services grew 14% in the last quarter, and experience strong growth in margins, posting margins of 30%, and 11% rise from prior levels. For the company as a whole, operating margins reached 41%, and the incremental margin exceeded 100%, demonstrating the great leverage of the company's business model.
NYSE Euronext will rise in 2012 no matter what happens with the Deutsche Borse merger. Should the merger succeed, NYSE Euronext will rise alongside Deutsche Borse, and shareholders will receive a great dividend. And should the merger fail, there will be no breakup fee to pay, and NYSE Euronext will be able to trade based on its own fundamentals, which are not reflected in the current share price.
For the record, the Reuters average price target for NYSE Euronext currently stands at $35.34, representing upside of 29.83% from current levels. NYSE Euronext is poised for success, and we think that shareholders who add to or initiate positions in the company at these levels will be rewarded.