As you may know, I'm a fan of stock exchanges. Businesses with high profit margins, strong network effects, and low marginal costs for additional revenue growth tend to deliver market-beating results over time. Generally, people look for these in a few select industries such as software. But there's plenty of other things out there such as airports and stock exchanges that enjoy similarly strong economics.
I've been a proponent of CBOE (CBOE) stock throughout 2019. However, it's far from the only listed stock exchange, and I've also taken a position in Nasdaq (NASDAQ:NDAQ). Here's why I'm still bullish on Nasdaq, even as the stock has just reached new highs:
If you haven't looked at a 10-K or annual report for a stock exchange company recently, you might be under the impression that they are essentially a toll operator that takes a tiny chunk of transactions as their cut of the action. And that's not wrong. But the business has evolved beyond just that. As it stands, market services and technology make up half of revenues, with the other half coming from elsewhere:
Source: Nasdaq's 10-K
What else is going on here besides collecting fees from operating the Nasdaq exchange? Much of it is information services, which we'll discuss more in a minute. There's also a great deal of R&D and rolling out of new technology products for financial products around the world. See this from Nasdaq's most recent 10-K:
Powering over 100 market infrastructure operators in more than 50 countries, our Market Technology business is a leading global technology solutions provider and partner to exchanges, clearing organizations, central securities depositories, regulators, banks, brokers, buy-side firms and corporate businesses. Our solutions can handle a wide array of assets, including but not limited to cash equities, equity derivatives, currencies, various interest-bearing securities, commodities, energy products and digital currencies. Our solutions can also be used in the creation of new asset classes, and in 2018, Nasdaq partnered with non-capital markets customers, including those in insurance liabilities securitization and digital advertising futures trading.
Nasdaq shares the features you like to see at investment banks or futures operations; they are constantly involved in the creation of new products. Competitor CME Group (CME) recently announced, for example, that it is launching futures contracts on 20,000-pound blocks of cheddar cheese. I'm not joking.
Some of these take off in a massive way, like the CBOE's VIX index. Many disappear entirely - it's trial and error. The potential for any of these new sorts of products to become the next VIX offering that gains widespread adoption offers huge potential upside. With Nasdaq providing the technological plumbing for all sorts of new financial products, be it insurance securities, digital advertising futures, blockchain, or something we haven't yet thought of, there's a good chance Nasdaq will be collecting recurring revenues off them for many years to come.
The nice thing is you get significant upside to all sorts of new and emerging trends without the risk of wipeout failure. If you buy a blockchain stock, or an independent smallcap payments company, for example, there's a good chance your investment ends up going to zero if things don't go exactly according to plan. With something like Nasdaq's stock, you are only paying 20x forward earnings for a high-quality business anyway, so if all the big future growth possibilities fail to play out, it's hardly a deal-breaker.
Many investors are familiar with this optionality as it applies to a huge business. Buy Alphabet (GOOG) (GOOGL) for the money-printing search business and if the moonshots hit, you get even more upside as a bonus. Or buy Facebook (FB) for the existing ads business and if they figure out how to monetize WhatsApp, you get a home run.
Sometimes investors don't carry out this thought process through to smaller companies though, where the option value can actually be worth more, in terms of moving the needle.
Consider something like Scotts Miracle-Gro (SMG), which has a good but low growth core business as lawns, golf courses, athletic fields, and so on aren't exactly booming industries nowadays. Throw in the marijuana trend, however, and Scotts suddenly picked up a free upside kicker; SMG stock, which had been flattish for a decade, has now doubled since 2015 as growth reasserted itself. By contrast, if you bought actual cannabis stocks, unless you traded them perfectly, you'd likely have large losses as most stocks in the sector are now down two-thirds or more from their peaks.
One thing you love to see is that Nasdaq has an active strategy to allocate capital in a profit-maximizing way. When you see language such as what I quote below, you tend to have a long-term focused management team that is building a business to last for many years, not just one that is focused on beating quarterly earnings to juice their stock options. To that point, in their 10-K, Nasdaq described its investment strategy:
Increasing Investment in Businesses Where We See the Highest Growth Opportunity. We have increased investment in areas that we believe help solve our clients’ biggest challenges and are likely to generate growth for our stockholders. In 2018, these businesses included: the data analytics business within our Information Services segment, [Nasdaq Private Markets], within our Corporate Services segment, and our Market Technology segment (including our regulatory technology business).
Consistent with this objective, we recently acquired eVestment and Quandl, Inc., which are part of our Information Services segment, and Sybenetix and Cinnober Financial Technology AB, or Cinnober, which are now part of our Market Technology segment. We also are investing further in the Market Technology segment through the Nasdaq Financial Framework, the expansion of our SMARTS products and customers, and our efforts to commercialize disruptive technologies, including blockchain, machine intelligence and the cloud.
Harrison Schwartz, in his recent article Nasdaq Struggling To Keep Up With Competition, argues that the stock exchanges will see declining margins like the brokerage business because barriers to entry are low. Schwartz wrote:
As I mentioned, revenue growth has been limited and data analytics sales have made up the bulk of revenue growth for older firms like Nasdaq. Unfortunately, the high margins on the data business will almost certainly decline over the coming years considering barriers to entry into that industry are not very high.
In fact, as witnessed by the ongoing broker "fee wars," I would argue that operating margins across the industry will decline. Many new exchanges are being introduced that are looking to undercut the competition. Indeed, it seems that technological improvements may be antiquating the underlying business model of financial exchanges as a whole.
I don't see this as a fair analogy, however. Data is proprietary, brokerage services are not. Hence one is more valuable than the other.
The brokerages are a middleman that helps clients buy and sell shares on the exchange. However, it's fairly easy to create alternatives to the brokerages, hence the downward spiral in commissions. The stock exchanges, by contrast are the actual limited good here. Without a stock exchange, how are buyers and sellers going to interact with each other? The brokerage industry couldn't function without stock exchanges.
Keep in mind that the stock exchanges are also highly regulated, and with good reason. How long do you think some hypothetical Fintech-powered crypto-trading "stock exchange" is going to last once it gets hacked and millions of dollars of stock disappear? Crypto is also a great example more generally, despite tons of media attention and money flowing into the space, it's done surprisingly little to disrupt traditional finance as of yet. And many of its most prominent headlines have been ones of fraud, scandal, and accidents that likely happened because of a lack of regulation. Think of Mt. Gox, Bitconnect, Quadriga, and so on.
Now, of course, it's possible to create disruptive stock exchanges within the existing regulatory structure. But then the question is, why bother? It's not like the fees CME, CBOE, Nasdaq, etc., are charging are so high that some competitor can come in, seriously undercut them, and still earn attractive margins. This is where network effects come into play. Companies want to list and traders want to operate on exchanges where there is already a critical mass of access, volume, and liquidity.
Back to Schwartz's point again. What's the competition for Nasdaq's data services? If you want detailed exchange data, where else are you going to go? In the course of running its business, Nasdaq assembles a vast trove of proprietary information, and it only grows more and more valuable over time as more funds rely on algorithmic trading. Are you going to use some cut-rate alternative to stock exchange data (if it's even available) to try to save a few bucks? If a brokerage hits somebody with too many fees, there's a ton of reasonable alternatives to get that service. If you decide Nasdaq charges too much money and you want proprietary information on Nasdaq-listed stocks, then what are you going to do?
That's a real moat, and as Nasdaq's rapidly-growing data services revenues show, it is a widening moat, not a feeble one. As Schwartz himself later notes, the real risk seems to be that the SEC stiffens regulations on data fees, not that some outside competitor offers a superior alternative.
By contrast, the SEC didn't have to demand that brokerages lower their fees; they did it of their own volition because they realized their business model had to evolve. This is a night and day difference from data services, where a few exchanges have a near-monopoly and customers are pleading for the government to lower prices.
Schwartz concludes by noting that Nasdaq stock has garnered support from its consistent dividend hikes, which is true. The company has a 26.7% CAGR dividend growth rate over the past five years, after all.
Source: Seeking Alpha
However, Schwartz further adds that:
Many investors and fundamentally-focused quant strategies buy companies with increasing dividends and often fail to account for increasing payout ratios as well as other fundamental factors. The reality is that Nasdaq cannot increase its dividend much more without a significant improvement in fundamentals [...]
Despite these large risks, Nasdaq is still priced like a high-growth technology stock.
This is where I disagree. I simply don't see how Nasdaq would be forced to forego meaningful dividend growth at this point. Nasdaq is currently paying out just 35% of earnings as dividends - and the payout ratio has been in the 30-35% range for the past couple of years. The company seems content on maintaining its dividend around this level, and keeping the dividend yield in the neighborhood of 1.5-2%, where it has traded in recent years.
Given Nasdaq's compounded 10% EPS growth rate over the past decade and strong balance sheet, it's hard to see a compelling reason why Nasdaq wouldn't kick out at least high single-digit dividend increases for years to come.
I also would push back on the idea that Nasdaq is priced "like a high-growth technology stock." 20x earnings for a business that grows EPS at 10% per year isn't a screaming bargain, but it's hardly a frothy valuation either, particularly for this market. And as Schwartz noted, Nasdaq is currently the cheapest stock on an earnings basis within the major U.S. exchanges space. That despite its operations continuing to perform well. To that end, consider that Nasdaq secured more than 150 IPOs which raised more than $30 billion this year. It also topped the NYSE in IPO volumes for just the second time since the turn of the century.
I've been an advocate of CBOE stock, and it remains my largest position within this category. But Nasdaq's discounted price compared to rivals forced it onto my radar as well. I expect that Nasdaq's long-term shareholders will be pleased over the next decade as management continues to invest wisely in high-growth opportunities while rewarding shareholders with steady earnings and dividend growth.
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Ian worked for Kerrisdale, a New York activist hedge fund, for three years, before moving to Latin America to pursue entrepreneurial opportunities there. His Ian's Insider Corner service provides live chat, model portfolios, full access and updates to his "IMF" portfolio, along with a weekly newsletter which expands on these topics.
Disclosure: I am/we are long NDAQ, CBOE, FB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.