TSX Group: An Undervalued Takeover Candidate

TSX Group (TSXPF.PK), the stock exchanges group of Canada, is the 7th largest stock exchanges group in the world by market capitalization of listed firms. TSX Group is attractively priced, with positive operating prospects, and therefore represents an attractive acquisition candidate. The exchange industry is rapidly consolidating, driven by the competitive advantage of larger exchanges vis-à-vis smaller exchanges in terms of capital raising for listed firms. Further, exchanges exhibit high operating leverage, and therefore mergers make sense from a financial and competitive standpoint. These factors make TSX Group a compelling long term buy at the time of the writing of this article (early 1/08).

TSX Group Overview

TSX Group holds the major stock exchanges of Canada, including the Toronto Stock Exchange, the Vancouver Venture Exchange, NGX, the main Canadian natural gas exchange, and, with the merger announced at 12/07, the Montreal Exchange. TSX Group holds strong positions in listed mining and oil and gas firms, as TSX is the largest exchange for mining as defined as the combined market capitalization of listed firms, and ranks #1 of all stock exchanges in terms of the total number of listed oil and gas firms.

TSX Group accrues income mainly from trading fees, listing fees and market data fees -- trading revenues has been the largest segment by revenue, representing 41% of TSX's 9 months 2007 revenue, while Listing fees (or "Issuer Services") comprised 32% of revenues and market data fees contributed 27% of the group's 9 months 2007 revenue. Note that TSX does not break out margins by operating segment, so trading appears to be the group's most significant segment in terms of profitability. All three of TSX Group's operating divisions grown at a high rate over from 2002 to 2006, with a compounded annual growth rate (CAGR) of revenues of 17%, and an EPS CAGR of 34%.

TSX Group Historical Financial Performance from 2000 - 2006

(click all charts to enlarge)

The Trading segment has demonstrated the fastest growth of TSX's three operating segments, growing at a CAGR from 2002 to 2006 of 21%, verses a CAGR of 19% for Issuer Services and 12% for the Market Data segments over the same period.

Trading volumes have increased due to a combination of increased trading by funds -- possibly (probably) hedge funds -- and day trading by smaller investors -- both of which, in turn, have been driven by the expansion, of the overall TSX index. TSX has instituted price cuts in its trading -- mainly in an effort (in the author's opinion) to enhance competitiveness vis-à-vis a proposed alternative trading system [ATS] backed by the major Canadian Banks (note that the risk of an ATS to TSX Group will be discussed in further detail below). However, the large rise in trading volumes, from an average of approximately 100 million shares traded per day in 2001 to an average of approximately 380 million per day at the end of the 3Q 07, has more than offset pricing declines.

Going forward, trading volumes will be a major driver of income for TSX Group, which will be driven by fund activity. It is possible that TSX Group may stabilize its pricing for trades, depending on its competitive position to the proposed ATS system -- this issue is dependent to a degree on the success of its new trading technology and resistance of customers to trade on alternative systems. (again this issue will be explored in more detail below).

In the Issuer Services segment, revenues have been driven by the growth in the market capitalization of existing issuers and a number of new (mainly resource based) Canadian firms that have gone public and/or raised additional capital over the past five years. Issuer services fees are based on new listings and a fee based on the market capitalization of the listed firms. The Canadian economy and stock and commodity markets, have done well, this segment has benefited. The market data segment has been driven by increased numbers of subscribers -- mainly financial firms and funds -- to its real time market data services, from under 100,000 in 2002 to 155,000 in 2007.

Valuation Comparison of TSX Group to Other Exchanges

A chart of the P/E's and growth rates of many of the worldwide exchanges is included in my other article on the Public Exchange Industry, which can be found here. The data in that article is not too dated at the time of the writing of this article, and, in summary, currently, the P/E ratio of TSX is very reasonable at 23.6x, compared to 37.5x for NYSE Euronext, 60.7x for the NYMEX and approximately 100x for the Hong Kong Exchanges Group. NYSE Euronext's earnings are forecasted to increase at a CAGR of approximately 23.6%, and NYMEX's earnings are forecasted to increase at a CAGR of 40.8%, both according to Yahoo finance. Note that author has not been able to find earnings projections for the TSX Group or the Hong Kong Stock Exchange, but as noted above, 5 year historical EPS CAGR for TSX is 34%.

Valuation Comparison of TSX Group to ASX Limited

Comparisons of Valuation with ASX Limited (Australian Stock Exchange) appears to be most appropriate on a comparable basis, due to the fact that Canada and Australia have similar economic structures (commodity and financial institution based economies), political systems and demographic situations. As shown in the chart below, ASX sells at a significant premium to TSX Group, as ASX is valued at approximately $US9.45Bn, while TSX Group is valued at approximately $US3.5Bn. The Canadian GDP is approximately $US1.18 Trillion, compared to the Australian GDP of $US675Bn (according to the CIA World Factbook), while Canada has a population of approximately 33.4 million people compared to Australia's 20.4 million. Based on these metrics, the discount of TSX Group compared to ASX Limited appears unjustified.

* Firms on exchange capitalization is defined as the sum of the market capitalizations of the equities listed on the exchange.

** Average daily volume is defined as the number of equity shares only traded per day -- for TSX Group, this measure only includes the Toronto Stock Exchange

Note that Australian dollars and Canadian dollars are translated at an exchange rate of $Aus/$US of 0.90 and $C/$US of 1.00.

Valuation of TSX Group Compared to Recent Exchange Acquisitions

Recent Merger activity within the Exchange Industry has priced acquisition targets at levels above TSX Group's current market valuation on a price to earnings basis, implying a premium purchase price to current levels if there is a takeover attempt of TSX. In Chart 2 below, valuations for the recent mergers of OMX (by NASDAQ), the Italian Borse (by the London Stock Exchange), the Montreal Exchange (by TSX Group) and the Takeover of the Philadelphia Stock Exchange by NASDAQ.

Valuations of Recent Acquisitions in the Exchange Industry

* Acquisition price, when priced in stock, is adjusted for the market value of the stock at early 1/08.

** Market Capitalization and other ratios of TSX Group do not include the Montreal Exchange.

The average p/e ratio of the 4 acquired firms above (price to earnings ratio defined as the purchase price divided by the historical earnings of the acquired exchange) is 33.8x, which is 43% above the current p/e ratio of the TSX Group (pre-merger with the Montreal Exchange). The price to revenues of the acquired exchanges is lower than TSX Group in 3 of the 4 acquisitions listed above, but note the price to earnings basis is the more appropriate measure to value exchanges, due to differing cost structures between firms -- TSX Group's margins are increasing with higher revenues, due to operating leverage.

Rationale for Acquisitions in the Exchange Industry

A good discussion of the flurry of merger and acquisition activity in the exchange industry can be found at Knowledge@Wharton. Exchanges are combining to take advantage of economies of scale -- trading technology can be applied to acquired exchanges, lowering overall operating costs, which translates to higher margins with higher revenues. Further, from a competitive standpoint, larger exchanges offer more choice to financial customers, as customers can trade across a larger, more diverse set of investment options, and, with mergers of exchanges located in different countries, across international boarders. Larger exchanges also offer potential listed firms a larger venue in which to raise capital, and higher liquidity for their shares, with tighter bid and ask prices. Additionally, larger exchanges pose stronger competitive advantages vis-a-vis brokerages and investment banks, which have complained that exchange industry fees are getting too high -- so potentially are exploring other trading options for shares and other financial instruments -- alternative trading systems -- that do not rely on the exchange to bring buyers and sellers together. With a large, established exchange, it is more difficult to "circumvent" this exchange verses a smaller, regional exchange.

TSX Group 9 Months ended 9/30/07 Update

TSX Group posted EPS increases of 22.7% to $C1.73 per share for the first 9 months of 07 compared to the 9 mo 06, on revenue increases of 19.7% to $C313.5M. Net margin increased slightly to 37.7% the first 9 months of 07 from 36.8% for the equivalent period in 06. As shown in the table below, the increase in net income was driven mainly by listing fee increases, and, to a lesser extent, by trading and market data revenue increases.

TSX Group 9 Months 2007 Operating Performance

* Trading Segment volume and market data includes the Toronto Stock Exchange and the TSX Venture Exchanges, but not Energy Markets (NGX), Shorcan Brokers (Fixed Income Trading). Note also that the newly acquired Montreal Exchange is not included in the 9 months 07 numbers above.

Risks

Alternative Trading Systems

The largest threat to TSX Group are alternative trading systems (or ATS's) to potentially circumvent Toronto Stock Exchange Trading earlier this year (in 5/07). An announcement concerning ATS developments in Canada sent TSX's market capitalization down 12.5%, details of which can be found in here. Canada may have as many as 8 separate electronic trading systems by the end of 2008 (details here). Note that the ATS that the banks have proposed is initially meant for large block trades -- which makes up less than 10% of the volume of TSX's trades currently -- and is similar to the 30 or so "dark pools" (ATSs) that exist in the United States, which trade mainly large blocks of securities between funds. ATS's could potentially climb to taking pieces of normal trading volumes in both countries with advances in technology and more willingness to place electronic trades.

Partially mitigating this risk of trading volumes going to ATS's is the fact that TSX has recently (in 12.07) launched what is one of the most technologically advanced trading platforms in the world -- named TSX Quantum -- which can complete trades in under 10 milliseconds (TSX's previous technology could complete trades in only several 100's of milliseconds). Details of the TSX Quantum launch can be found here. TSX Quantum is comparable to NYSE Euronext's new service which will be launched in 2008 with processing times of 10 milliseconds Note that NYSE Euronext is generally thought of by financial professionals to be the leader in terms of trading technology, so the favorable comparison with the NYSE is impressive for TSX Group. According to the CEO of the TSX Group, generally the exchange with the faster processing times will win the trade, all other factors equal. Further, faster technology for processing trades allows volumes to go higher without corresponding cost increases.

According to Jackie Chung, president of Competitive Metrics Inc in Canada (which recently completed a report on ATS's in Canada), it is likely that the launch of ATS's in Canada will result in a somewhat smaller piece of a larger trading pie, but Chung also notes that TSX Group will be a fierce competitor with the new "dark pools." However, it is not exactly clear to what extent the ATS's will impact trading volumes at TSX Group, so investors are encouraged to watch developments concerning ATS's closely going forward.

TSX Susceptible, But Resistant to a Market Downturn

It is believed by some exchange industry participants that the exchange industry "will make money if the market goes up or down." In the recent book "Rigged" by Ben Mezrich published in 2007, the Executive Vice President of Strategy for the MERC expressed this viewpoint -- due to the fact that trading volumes can stay the same or perhaps even rise in a declining market. But the recent history of the TSX shows that a rising market is better for the exchange's profitability, and, as demonstrated in chart 1 above, TSX Group suffered a drop in revenues of 17% and a decline in net margin to 16.8% from 35.3% from 2001 to 2002, mainly due to the market downturn in these periods. Earnings did not decline to negative territory as would have been expected in an industry such as machine tools, but revenues and margins were significantly negatively affected, and therefore the recent history of the TSX shows that a rising market is better for the exchange's profitability.

Partially mitigating recession risk is the diversification of TSX Group, which operates in both commodity-based (mainly through the trading of mining and oil and gas equities, but also through TSX's natural gas exchange, NGX) and equity trading. Diversification was a different issue during the last downturn (2002) due to the fact that commodities were not valued then as highly as they are currently. Certain analysts -- recently the chief economist at BHP has expressed this opinion -- have projected that if there is a slowdown in the US, China and other emerging markets will not be dramatically affected, and commodity prices will continue to stay relatively strong, which would benefit TSX Group.

Conclusion

TSX Group is attractively priced and is a good acquisition candidate in the exchange industry, which is undergoing significant consolidation. As such, TSX Group represents a compelling medium to long term buy. The largest risk to TSX Group is the proposed Alternative Trading Systems for potential launch in 2008, although this risk is partially mitigated by the fact that most of the systems are designed for mainly large block trades, and the fact that TSX Group has much more advanced (faster and more reliable) trading technology for the completion of trades. Further risks include the risk of recession in the US that chokes off Asian growth and negatively affects the Canadian economy. Interested TSX Group investors are encouraged to closely watch developments with regards to Alternative Trading Systems and the global economy closely going forward.

Comments

[Vlad Khandros:]

A number of the ATSs in Canada have already launched such as Liquidnet in 2006.

Block volume as a share of total volume will increase in Canada as it has in the US thanks to block trading ATSs that offer successful models. The market impact cost of trading blocks in a displayed market is too high for many names and many large orders. This is the only market that penalises customers for having wholesale supply/demand – retail sized order flow is all that can be given on the exchanges and institutions are forced to splice up their blocks into algos while simultaneously revealing their hand to the brokers. Again, ATSs are changing this.

In regards to the TSX having a lower valuation than the ASX - as of today there are certain regulatory restrictions in Australia that make the ASX's order flow more "sticky." Also the ASX is multi asset while as the TSX will not be until the MX merger is complete.

2008 Jan 04 07:53 AM

[Randy Kirk:]

Vlad Khandros -- thanks for that comment. I was going to write something on TSX Group's option (puts and calls) performance going forward but the article was getting a bit lengthy -- I can do it in a future article. With the acquisition of Montreal Exchange options revenue should obviously increase. The option discussion would be to compare trading revenue sources with ASX Limited, which receives (if my memory serves me correctly) about 20% of total income from options trading. TSX does very low levels of option equity trading now -(as you noted), but does do bond trading through Shorcan nad natural gas futures through NGX. I would still argue that the valuation of ASX at approximately $US9.5Bn verses TSX Limited's $US3.5Bn is excessive -- by p/e ratio and historical earnings growth rates and also given that TSX is moving into options trading.

I am curious, can you elaborate on why ASX Limited's trading is "sticky"? Does regulation prohibit I-banks from trading down there? I am not familiar with this regulation.

Going forward, in terms of Alternative Trading Systems, one thought I didn't include in the article, as it is a bit speculative, was that I don't think ATS's will take away the majority of the volume from the major exchanges over the long term, due to the fact, that ATS's are run by the major investment banks (almost entirely) and these I-banks are extremely competitive -- so one will not want the other to develop a majority position in trading. Let's say one of the Canadian banks effectively takes away trading of some of the major listed co's onto their own system - not only would this require a new regulatory (governmental) infrastructure, -- for the interest of funds and other customers who would not want to see unethical behavior (front loading, etc) -- but also would cause extreme tension between the other i-banks, who would be cut out of the deal. Further, having a public exchange separate from direct i-bank control is good for the public, funds and listed firms, and their confidence of the markets -- less conflicts of interest. Not to say one i-bank won't try to dominate trading, but there will be resistance from not only the exchange but the other i-banks, and perhaps the government -- for the overall confidence in the markets.

Knowing this, a good exchange CEO will play i-banks off each other so none of them will gain majority control through ATS's, and can also make pleas to the government and public, in addition other defenses such as introducing superior trading technology, cutting fees, etc.

By the way, according to comments from the former Chairman of the MERC, according to the book "Rigged" and according to Richard Grasso, according to the book "King of the Club" -- both were not sure of the future of ATS's and electronic trading -- the former Chairman of the MERC spent a large amount of time studying electronic trading and it was Grasso's opinion -- which he negotiated with the i-banks, not to have any one of the i-banks attempt to dominate trading due to the fact that they all would be too competitive with each other. (well, then after Grasso was ousted Goldman effectively introduced their trading system onto the NYSE, but this is informative, in that, Goldman did it through the exchange so it was a situation in which both Goldman and the NYSE shareholders benefited, not a situation in which Goldman benefited and the NYSE did not).

2008 Jan 04 05:41 PM

[Vlad Khandros:]

Regulatory restrictions on off exchange trading in Australia as of today give the ASX essentially a fixed near total market share. Such restrictions do not exist in the North America and European equity landscapes.

ATSs are not only run by investment banks. The top four independent ATSs (Liquidnet, ITG, NYFIX, and Pipeline Trading) account for about 400mln shares per day including DMA. ATSs in the US on an aggregate basis, where the equity markets are the most developed, have built up a near 20% market share. The liquidity residing in these systems will be the determinant of their future success. Whether or not an investment bank owns an ATS, the Chinese walls are required by wall no matter what. If you believe ownership negatively impacts the public’s confidence in the public markets, how can you also encourage the trading on stock exchanges that are now publicly listed and controlled by shareholders…many of which are the same firms? Publicly owned exchanges now have their stakes controlled by financial firms that can push them in certain directions as well. I am not saying this is reason for concern, but ownership does not necessarily translate into a loss of confidence. Best ex requirements require all to go wherever the best price is and a fund cannot be meeting their fiducial responsibilities if they are not accessing a significant amount of off exchange liquidity.

Exchanges themselves see the value is non displayed liquidity and are beginning to embrace this. The NYSE has formed a joint venture with a broker owned block trading ATS in the US dubbed BIDS and is launching an ATS in Europe as well dubbed SmartPool. Exchanges that do not follow will continue to lose substantial market share as is already happening.

2008 Jan 06 01:37 AM

[Randy Kirk:]

Again, thanks for the insightful comments. Actually I wasn't thinking too clearly in my previous comment -- it wouldn't be in all likelihood a real possibility that an exchange could state that "it is bad for society" and have this be a deterrent towards increased off exchange trading. Also I have a clarification, in that, what I was referring to in terms of ATS was a situation that Richard Grasso referred to the book "King of the Club" -- in that an i-bank or other independent ATS would effectively take 80+% of the trading of listed firms onto its own systems -- leaving low trading volumes on the exchange's systems. This first round of ATSs is most likely win-win, as the large volumes would increase liquidity for the larger names and block trades, as you've mentioned above. What the exchanges fear is, something akin to the NYSE losing names to NASDAQ -- the firms simply going to ATS's directly without dealing with the exchange.

2008 Jan 07 11:19 PM