The Publicly Held Exchange Industry: Is There Any Value Left?

Includes: CME, NDAQ, NYX
by: Randy Kirk, CFA

The publicly owned exchange industry is comprised of the firms that own and operate the world's major and minor stock and commodity exchanges. The exchange industry is a relatively "new" industry, in the sense that almost all of the publicly owned exchanges went public -- that is, demutualised (meaning to transition to a for-profit corporation from not for profit) -- from 2000 onward.

Most of the largest exchanges are now, as of 2007, publicly owned including the NYSE Group (NYSE:NYX), NASDAQ (NASDAQ:NDAQ), the Hong Kong Exchanges Group, the Chicago Mercantile Exchange (NASDAQ:CME) and London Stock Exchange, for example. Notable exceptions are the AMEX (which plans to demutualise in 2007 to 2008), all Indian and Mainland Chinese exchanges, all Japanese exchanges, and all Latin American (exchanges except those with ties to BME of Spain).

Exchange Equities Have Exploded over the Past Three Years:

Based on a comparison of the stocks in the industry (as shown in an appendix to this article) certain facts and trends are evident. First, there are few bargains in the exchange universe, with current P/E's (at 10.07) of 30x or more, up to 60x, due mainly to very high stock appreciation across the board in the industry. Most of the appreciation has occurred in only the past two years and, in certain cases, only in 2007. For example, OMX Group - which represents the stock exchanges for the Nordic Countries -- Stockholm, Copenhagen, Finland, Island, and the Baltic Countries -- has appreciated approximately 70% this year and mainly in March and April 07, from relatively flat performance in 2005 and 2006. Stock performance has been extremely positive even challenging commodity based stocks in total return since 2004.

The high appreciation has led to quite high valuations for certain exchanges, if to compare with valuations in other industries. For example, CME -- Chicago Mercantile Exchange -- is valued at approximately 20% more than Cameco (NYSE:CCJ) in terms of market capitalization -- $19.5Bn vs $16.5Bn. Cameco is the world's largest miner of Uranium, providing 20% of the world's supply of newly mined Uranium, while CME is one of three US based commodity exchanges, albeit the largest, and one of several international commodity exchanges, so faces significant competition. Additionally, major commodity exchanges are planned to open in the Middle East and Russia -- translating to potentially more competition going forward in the commodity exchange industry.

Trading Volume is The Key Driver of Income

Second, it becomes clear that the number one driver of earnings for stock based exchanges are fees on trading volume. Exchanges earn income in three main areas:

  1. Transaction fees: a small fee per transaction, typically well less than 1 cent per share, but dependent on the exchange,
  2. Listing fees, based on a flat fee year per company and new fees per company IPOs, and
  3. Information services, outsourcing their trading technology to other exchanges and partners.

Surveying the publicly held exchange firms, fees on trading volume for almost all of the exchanges is the largest profit center, and also is the fastest growing profit center across firms in the exchange industry. For example, the Oslo Stock Exchange -- a quite small regional exchange by international standards (but still with a current market capitalization of $US550M!) -- earned 62.7% of total 2006 operating income in equity trading fees, and 28% from information services. For Oslo, equity trading fees were up 45% in 2006 and 49% in 2005 year over year, while information services also grew at a good clip, 33% in 2006 but only 7% in 2005.

Numbers of listed firms has been relatively flat across most of the stock exchanges, with the single exception (of the firms listed above) of the London Stock Exchange, which has seen approximately a 10% annual increase in numbers of firms listed since 2002. Part of this reason may be Sarbanes Oxley in the United States, which has made cost and compliance burdensome for public firms. Nevertheless, trading fees have been a much higher driver of profits for London than exchange listing fees.

Note also that it is possible for the exchanges to come up with new products that could potentially be popular with investors and lead to higher fees, based on revenues from these products, such as interest rate derivatives, new index funds, etc. However, in the introduction of these products, the exchanges will compete with the major brokerages for market share.

For Some Exchanges, Higher Fees Are the Main Driver of Trading Volume Revenues

Trading volume revenues can increase either from 1) higher trading volume or 2) higher fees per share traded. For Nasdaq and NYSE Group, the volumes traded have not increased by more than 10% over the last 3 years, but income has increased well in excess of 30%. This is mainly due to higher fees, although fee information is difficult to find in the exchanges' financial statements (10-k's and other financial documents). Investors should be cognizant that there are already grumblings in the major brokerages that the fees are becoming too high. Citigroup (NYSE:C), for example, has instituted a group to investigate a separate system to trade shares that does not depend on the major exchanges' systems, to combat high fees (see here).

In addition, the investor should also be wary of steep rises in trading volume in international markets. For example, the Australian stock exchange has experienced trading volume increases of 50% in 2006. Perhaps this is due to increased activity by funds and hedge funds internationally. But, in comparison, the New Zealand Stock Exchange [NZX], with a somewhat similar economy and demographic situation, has seen flat to slightly declining trading volumes in 2007. The NZX's CEO's conclusion regarding flat to lower trading volume is that trading volumes will always be cyclical and this is good advice for the investor -- to be mindful of the cycle of the exchange and economy in terms of trading volume -- but on the positive side as countries experience economic growth generally over time trading volume will increase.

Does Value Exist in the Exchange Industry?

A significant percentage of the future profitability of the exchange industry depends on the robustness of financial market conditions. As discussed above, exchange income is driven by the trading volumes and (to a lesser extent) introduction of new financial products, technology sharing and listing fees, which are all driven by the situation in financial markets. Although markets are becoming more correlated globally, there are still significant difference in the health of financial markets globally based on region and country. Countries and regions with brighter prospects – such as Asian countries and countries with a young population, significant natural resources, and a stable legal investment climate -- would likely have more appealing stock exchanges for investment, all other factors equal. For example, in this current year (2007), Chinese related exchanges have performed extremely well due to the rise in the Chinese stock market, driving the value of the Hong Kong Exchanges to a staggering $US35Bn market capitalization and a 100x price to earnings ratio (in comparison, the London Stock Exchange’s market value is $US8.4Bn.)

In terms of picking specific names, overall, the London Stock Exchange, NASDAQ, Oslo and TSX Group (Canada) mainly stand out as potentially undervalued currently. Oslo is on this list due to the relatively low p/e ratio of 13x -- but the exchange appears overvalued on first glace due to its market value of $US550M, serving as the main exchange for a country of only 4 million people.

TSX Group is interesting in that it has a relatively low P/E at 18x forecasted for this year -- the forecast, as the author has been unable to find an analyst that provides an estimate, has meant taking the 2nd quarter income of approximately $C40M and annualizing this number. TSX Group has moderate but relatively steady prospects for growth in revenue and income. TSX showed an approximate 20% increase in income for the first six months of 2007. TSX does not appear to be aggressively increasing pricing on trading – TSX mentioned that it may discount trading costs in an effort to drive up volume in its 2Q 07 financial report -- which may drive lower income in the short term but may mean less effort by investment banks and funds to circumvent TSX trading over the long term. Canada’s economic prospects are positive as long as commodity prices remain high, as the country is very rich in natural resources, including oil (oil sands), uranium, nickel, and potash, among other resources. Interestingly, TSX Group was the first North American stock exchange to demutualise, in 2002, but now trades at a discount to the US exchanges, at approximately $US3Bn in market capitalization compared to (for example) $35Bn for the Chicago Mercantile Exchange.

NASDAQ also appears undervalued at an Enterprise Value of $3.9Bn, and a P/E ratio of 20x forecasted for 2008. NASDAQ is an electronic only exchange, and was founded in the 1970’s. Note that the author has not fully analyzed NASDAQ’s prospects so is not in a position to judge the attainability of NASDAQ’s earnings projections.

The London Stock Exchange Appears The Most Undervalued

London has appreciated significantly in the last two months with the announcement of an additional investment by the Dubai Investment Authority, but it still remains (in the author’s opinion) relatively undervalued compared to the rest of the exchange industry. London Stock Exchange as posted very strong volume growth (+33% in 2006) that appears more sustainable than other smaller international exchanges, as it is the major regional center and is well positioned against the US exchanges as the key world financial center. Europe as a whole is showing solid – if currently weakening slightly -- economic growth, coming off a low growth base with economic reforms instituted. The CEO has publicly stated that the market capitalization of $5.1Bn at 6/07 is undervalued (although currently the market capitalization has risen to $8.4Bn) (and therefore will not accept the $5.1Bn bid from NASDAQ, although it is possible that prestige issues may also be present in the decision not to sell to the relatively upstart NASDAQ). London's p/e is reasonable in comparison with the industry at approximately 40x 2006 earnings. Additionally, London Stock Exchange will remain attractive to Sovereign Wealth Funds, due to the prestige issues and the relative undervaluation of London compared to the rest of the exchange industry.

Disclosure: The author holds a long position in London Stock Exchange


Data on Selected Public Exchanges Worldwide at of 10/07 (foreign currencies are translated at exchange rates to SUS at 10/07):