IPO Preview: BATS Global Markets

Mar.22.12 | About: BATS Global (BATS)

Based in Lenexa, Kansas, BATS Global Markets (proposed BATS) scheduled a $107 million IPO with a market capitalization of $809 million at a price range mid-point of $17 for Friday, March 23, 2012.

BATS is one of six IPOs scheduled for this week (see our IPO calendar) with nine more on deck for the week of March 26.

SUMMARY
BATS develops and operates electronic markets for the trading of listed cash equity securities in the United States and Europe and listed equity options in the United States. Founded in 2005 with 13 employees BATS became profitable after its second year.

BATS is third largest exchange operator in the United States after NYSE Euronext (NYSE:NYX) and The NASDAQ OMX Group (NASDAQ:NDAQ). Unlike traditional market operators, BATS is a technology company at its core. BATS developed, owns and operates the BATS trading platform.

Including fees BATS is required to collect, proforma revenue for 2011 was $1 billion.

BATS has captured market share during a time when its overall market suffered respective declines of 11% and 4% respectively for 2010 and 2011.

CONCLUSION
On a price-to-book basis BATs is expected to IPO at a premium to both NYX and NDAQ. At the price range mid-point BATS would be priced closer to NYX than NDAQ in the terms of P/E multiples.

Sector stocks have increased somewhat since the beginning of February.

In this fairly warm IPO market for technology companies, BATS appears to be a buy on the IPO, and depending on where it trades may be interesting in the IPO after market.

BUSINESS
BATS is an innovative global financial technology company that develops and operates electronic markets for the trading of listed cash equity securities in the United States and Europe and listed equity options in the United States.

Unlike traditional market operators, BATS is a technology company at its core. BATS developed, owns and operates the BATS trading platform.

With the exception of Chi-X Europe, which will be transitioned to BATS platform during 2012, BATS proprietary platform powers all of its markets and is designed to offer one of the fastest and most reliable trading systems available.

BATS is the third-largest exchange operator in the United States after NYSE Euronext and The NASDAQ OMX Group, Inc.

BATS also executes the largest notional value of pan-European equities traded by a single market operator through two Multilateral Trading Facilities (MTFs).

For the year ended December 31, 2011, BATS had an 11.3% share of the U.S. equity market and a 3.1% share of the U.S. equity options market.

BATS has captured market share during a time when its overall market suffered respective declines of 11% and 4% respectively for 2010 and 2011.

DIVIDEND POLICY
On February 22, 2012, BATS approved a cash dividend of $100 million to stockholders of record as of the close of business on the day immediately prior to the closing of the IPO. The dividend is conditioned upon the successful completion of this offering, and purchasers in this offering will not be entitled to the dividend.

No further dividends planned.

DUAL STOCK CLASSES
Class A common stock has one vote per share. Class B common stock has two and one-half votes per share.

Class A common stock will have 34 million shares. Class B common stock will have 13.3 million share.

HISTORY
Founded in 2005 with 13 initial employees, BATS became profitable within first 2 years.

BATS was founded as an alternative to the New York Stock Exchange, and The NASDAQ Stock Market in response to increased consolidation among U.S. listed cash equity market centers.

In January 2006, BATS launched an electronic communication network, or ECN, a type of alternative trading system, or ATS, which initially focused on the trading of NASDAQ-listed securities.

BATS began trading in American Stock Exchange (now NYSE Amex)-listed securities in May 2006 and in NYSE-listed securities in February 2007.

In March 2008, BATS decided to enter the European markets by launching an MTF to compete on a pan-European basis against the incumbent securities exchanges, formally launching BATS Europe in October 2008.

In November 2008, BATS converted its ECN to a national securities exchange, BZX, which allowed BATS to participate in and earn market data fees from the U.S. tape plans, reduce clearing costs and operate a primary listings business.

In February 2010, BATS expanded into a new asset class by offering trading of listed equity options on BZX. In order to grow U.S. market share, in October 2010, BATS launched BYX, a second national securities exchange for trading listed cash equity securities.

In November 2011, BATS acquired Chi-X Europe and it became a wholly-owned subsidiary of BATS Global Markets, Inc.

In December 2011, BATS launched a primary listings business in the United States on BZX.

OPERATIONS
In the United States, BATS operates two national securities exchanges, BZX and BYX. Both trade listed cash equity securities and exchange-traded products, such as exchange-traded funds, or ETFs, but each targets different market segments by offering different pricing alternatives. BZX also operates a market for trading listed equity options.

In Europe, BATS MTFs operate two displayed books and offer trading in listed cash equity securities from within 25 European indices, in addition to ETFs, exchange-traded commodities and international depositary receipts.

The BATS platform is designed to facilitate price discovery by encouraging the quoting of competitive, displayed prices. BATS platform also offers opportunities to post undisplayed, or "dark," trading interest on our U.S. and European order books, and in Europe, we operate two dark pools.

MISSION
BATS principal objective is to make markets better by minimizing inefficiencies and mitigating trade execution risk for market participants. BATS minimizes inefficiencies in part by offering low-cost, rapid, trade execution.

For example, during the second half of 2011 BATS net capture rate in the U.S. equities market was 56% to 68% of the rate reported by NYSE Euronext's and NASDAQ OMX Group's U.S. equities operations, while BATS net capture rate in the European listed equity securities market was 15% of the rate reported by the London Stock Exchange's European equities operations.

During the fourth quarter of 2011, BATS net capture rate in the U.S. listed equity options market was 25% to 28% of the rate reported by NYSE Arca, NYSE Amex, NASDAQ Options Market and NASDAQ OMX PHLX.

Mitigates Risk
BATS mitigates trade execution risk through offering ultra-low latency order handling through its trading system. In particular, by offering ultra-low latency order handling, members can very quickly place, modify or cancel orders on markets. This ability gives our members greater control over their orders, enabling them to rapidly respond to changing market conditions and mitigate trade execution risk.

MARKET SHARE
90.7% of BATS total revenues came from trading of listed cash equities securities in the United States for the year ended December 31, 2011. In Europe, for the eleven months ended November 30, 2011, BATS had a 5.7% share of European trading in the securities available for trading on BATS Europe.

On November 30, 2011, BATS acquired Chi-X Europe, the operator of the largest pan-European MTF.

For the eleven months ended November 30, 2011, Chi-X Europe had an 18.4% share of European trading in the securities available for trading on Chi-X Europe.

For the month ended December 31, 2011, BATS Chi-X Europe had a 25.4% share of European trading in the securities available for trading on BATS Chi-X Europe, making it the largest pan-European equities trading venue.

Pro forma for the acquisition of Chi-X Europe and assuming BATS had acquired the business on January 1, 2011, for the year ended December 31, 2011 BATS would have derived 84.1% of total revenues from the trading of listed cash equities securities in the United States, 5.8% of total revenues from the trading of listed equity options in the United States and 10.1% of total revenues from the trading of listed cash equities securities in Europe.

BATS also would have had a 24.1% share of European trading in the securities available for trading on BATS Chi-X Europe during 2011.

STRATEGIC INVESTORS
BATS generates a significant percentage of total revenues from, and are provided with significant liquidity in its markets by, customers who are affiliates of its strategic investors. Those investors are not contractually obligated to continue to use BATS services or purchase BATS products. Those investors also use the services of BATS competitors.

For the years 2011, 2010 and 2009, 29.4%, 31.7% and 29.8% of BATS total revenue, respectively, was generated by affiliates of BATS strategic investors. S-1 page 22

None of the strategic investors accounted for more than 10% of BATS total revenue during the years 2011, 2010 or 2009.

For the years 2011, 2010 and 2009, 31.3%, 41.8% and 53.7% of total cost of revenue, respectively, was generated by affiliates of BATS strategic investors.

In addition, affiliates of BATS strategic investors also provide BATS with liquidity for which BATS provides a rebate.

For the years 2011, 2010 and 2009, an affiliate of one of BATS strategic investors accounted for 13.2%, 31.0% and 51.0% respectively, of total liquidity rebates paid.

None of BATS customers is contractually or otherwise obligated to continue to use BATS services or purchase BATS products. In addition, affiliates of BATS strategic investors and other customers have made, and may continue to make, investments in businesses that directly compete with BATS. BATS customers also trade, and will continue to trade, on markets operated by competitors.

SEASONALITY
BATS experiences seasonal fluctuations, reflecting reduced trading activity generally during the third quarter of each year and during the last month of the year. As a result, operating results for the third or fourth quarter of any year may not be indicative of the results BATS expects for the full year.

INDUSTRY TRENDS
Significant regulatory and technological developments have transformed the markets in which BATS operates and have been the primary drivers of BATS growth and development.

  • U.S. Listed Cash Equity Securities. Several regulatory developments, together with innovations in technology and improvements in the speed of communication, have fundamentally changed the way U.S. listed cash equity markets operate. Notable developments that encouraged the creation of alternative markets, like BATS original ECN, included:
  • The adoption of the "order handling" rules in 1996, which facilitated the growth of ECNs as alternatives to national securities exchanges for displaying and executing orders;
  • The move to decimal pricing in 2000, which resulted in narrower trading spreads, providing automated market makers with an advantage over traditional market makers; and
  • The adoption of Regulation NMS in 2005, which provided price protection for each exchange's best displayed quotes that are electronically accessible for immediate trade execution, and resulted in a dramatic shift to electronic trading as exchanges automated their trading systems to take advantage of this price protection.
  • European Listed Equity Securities. The implementation of the Market in Financial Instruments Directive, or MiFID, in 2007 marked a fundamental change in the European market for trading listed cash equity securities. MiFID was designed to increase competition in pan-European trading and authorized the creation of MTFs. In particular, to create competition among markets, MiFID abolished the "concentration rule," which required firms to route orders only to national stock exchanges, and extended the concept of "passporting," which allowed firms authorized to carry on business in one European Economic Area, or EEA, member state to carry on business in other EEA member states.
  • U.S. Listed Equity Options. The most significant recent changes within the U.S. listed equity options market have been the move to penny-increment price quotes and the shift away from the traditional pricing model, pursuant to which both sides pay a fee, for executing trades. The conversion of the U.S. listed equity options market from nickel- or dime-increment price quotes to penny-increment price quotes began in January 2007 and has contributed to significant growth in overall options market volume, particularly among electronic traders.

Additionally, the traditional exchange pricing model in the U.S. listed equity options market, pursuant to which both sides of a transaction generally pay a fee to the exchanges, is increasingly being supplanted by a pricing model common in the U.S. listed cash equities market that we believe encourages more aggressive competition and better price discovery.

PRICING ADVANTAGES
The scalability of BATS technology platform and the efficiency of BATS operations allows the company to continue to grow with limited additional capital investment.

BATS uses technology to leverage its products and employees across multiple asset classes and geographies. As a result, BATS is able to operate with lower overhead than many incumbent exchanges. In addition, as a new business, BATS is not burdened by legacy infrastructure.

With fewer than 170 employees globally as of December 31, 2011, BATS has captured substantial market share from traditional exchanges in the United States and Europe while maintaining substantially lower fixed costs.

Due to operating leverage, BATS is able to profitably employ an aggressive, low-spread pricing strategy, which BATS believes provides an important competitive advantage.

In addition, BATS has employed innovative, and in some cases, disruptive pricing strategies to increase market share.

To drive market share, BATS implemented strategic pricing changes in its U.S. Equities segment in July 2011, through which BATS recognized $14.6 million more in net revenues during the year as a result of an increased net capture rate.

These changes included the implementation of a tiered pricing structure that not only contributed to higher market share, but also resulted in a higher net capture rate. Had BATS implemented this change for the full year and assuming no change in volume, this would have resulted in an incremental $12.1 million more in net revenues.

BATS also made a pricing change in its U.S. Options segment in August 2011, through which it recognized $5.3 million more in net revenue. Had it implemented this change for the full year and assuming no change in volume, BATS would have resulted in an incremental $6.2 million more in net revenue.

COMPETITION
Market participants now have multiple venues for the execution of orders. In addition to national securities exchanges, in the United States, these venues include numerous ATSs, many of which operate as "dark pools" and broker-dealers who internalize orders for execution. In Europe, these alternate venues include MTFs that operate "lit" books and/or "dark pools," broker crossing networks and other broker-dealers who internalize orders for execution.

BATS competes in the U.S. listed cash equity securities market against NYSE Euronext , NASDAQ OMX , Direct Edge, other regional exchanges and several ATSs.

In Europe, major competitors include London Stock Exchange, NYSE Euronext, Deutsche Börse, NASDAQ OMX, SIX Swiss Exchange and BME, as well as Turquoise.

BATS competes in the United States in listed equity options against CBOE, NYSE Euronext, NASDAQ OMX, ISE and BOX.

In the United States, the competition among exchanges and other execution venues has become more intense with regulatory changes.

The U.S. listed cash equity securities marketplace has evolved dramatically in recent years following the SEC's adoption of Regulation NMS. BATS competes in the U.S. listed cash equity securities market against NYSE Euronext, NASDAQ OMX, Direct Edge, other regional exchanges and several alternative trading systems, or ATSs.

As noted, market participants now have multiple venues for the execution of orders, including national securities exchanges as well as numerous over-the-counter options, including ATSs operating "dark pools" that do not publicly display quotations, ECNs and broker-dealers who internalize orders.

For example, dark pool venues compete with BATS by offering low cost executions and differ from lit ATSs and MTFs in the degree of transparency with respect to quotes and trades they offer and in restrictions on who may access these systems.

Unlike "lit" venues that publicly display orders, dark pools do not display orders publicly or privately. In addition, while dark pools are required to publicly report trade executions, unlike lit venues that are national securities exchanges, such as BZX and BYX, those public reports do not identify the dark pool responsible for the trade execution.

Hence, dark pools are less transparent than lit venues. Moreover, dark pools below a certain size have discretion to offer access on discriminatory terms, effectively blocking access to certain types of market participants. These features of dark pools can appeal to trading participants who seek to minimize the public disclosure of their trading interest or limit the types of other trading participants that can access their orders.

In addition, various broker-dealers internalize their order flow or route their orders to third-party ATSs. Based on publicly available data regarding reported trades, for the year ended December 31, 2011, over-the-counter trading accounted for in excess of 30% of consolidated U.S. equity volume. If over-the-counter trading expands further, it will adversely affect BATS market share in the United States.

EUROPE & MiFDs
The market for execution services within listed cash equity securities in Europe has become significantly more competitive since the Market in Financial Instruments Directive, or MiFID, went into effect in 2007.

MiFID created a structure for pan-European competition versus incumbent exchange monopolies throughout the European Union countries.

As a result, new Multilateral Trading Facilities (MTFs) have emerged and have begun to capture significant market share from existing exchanges, particularly the London Stock Exchange.

Following these developments, London Stock Exchange acquired a majority interest in Turquoise Global Holdings Limited, an MTF that offers pan-European trading.

Major competitors in Europe, other than LSE, include NYSE Euronext, Deutsche Börse AG, NASDAQ OMX, SIX Swiss Exchange and Bolsas y Mercados Españoles as well as Turquoise. Some of these competitors have themselves launched MTFs.

U.S. listed equity options
The market for the trading of U.S. listed equity options is also intensely competitive, with nine authorized U.S. options exchanges as of December 31, 2011 vying for market share, and is in the midst of significant change, driven primarily by recent regulatory changes.

Primary competitors in the options market are the Chicago Board Options Exchange (NASDAQ:CBOE), NYSE Euronext , NASDAQ OMX , International Securities Exchange Holdings, Inc., and Boston Options Exchange Group, LLC, Moreover, some products offered uniquely by CBOE (for example, products based on the VIX volatility index) represent products that are not traded on the BATS platform.

In addition, some competitors, including NYSE Euronext, NASDAQ OMX and CBOE, offer multiple trading venues for equity options that use different pricing strategies, which allow them to potentially appeal to a broader customer base.

BATS may face competition from strategic investors. BATS strategic investors or their affiliates may already have or may acquire an ownership interest in competing businesses (including national securities exchanges, dark pools, MTFs, ATSs or ECNs).

These businesses may compete with BATS, either in relation to existing product and service offerings or any diversification of BATS product and service offerings into new asset classes and/or new geographic locations. For example, certain of BATS strategic investors have a material interest in another MTF, Turquoise. Furthermore, many of BATS strategic investors operate market-making desks, dark pools, "lit" ATSs and ECNs and smart order routers, each of which potentially competes with BATS.

EMPLOYEES: 170 as if December 31, 2011

SHAREHOLDERS
Include Citigroup Financial Products, Inc.; Credit Suisse First Boston Next Fund, Inc. ; DB Investment Partners, Inc. ; GETCO Strategic Investments, LLC ; Instinet Holdings Incorporated ; Lime Brokerage Holdings LLC ; Lehman Brothers Holdings Inc. ; ML IBK Positions, Inc. ; Strategic Investments I, Inc. ; Tradebot Ventures Fund 1, LLC; ML UK Capital Holdings ; Nomura International plc.

USE OF PROCEEDS
100% to repurchase Class A stock from shareholders

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: BATS is the focus ticker. The company expects to price Thursday evening for trading Friday.