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Who's Next In The Exchange Merger Mania?

 February 14, 2011 04:00 PM
 


On Wednesday of last week, the Deutsche Boerse announced that it was in advanced talks with NYSE Euronext (NYX) to combine into the world's largest exchange.  This came just hours after the London Stock Exchange (LSE) announced its merger with the TMX Group, which runs the Toronto and Montreal exchanges.  

Both of these mergers followed last year's proposed acquisition of the Australian Stock Exchange (ASX) by the Singapore stock exchange, which has yet to be approved by the Australian government, but appears to be making progress.

Of course, the NYSE/DB tie-up took center stage in the US since it is the only one easily accessible by US investors, and also because it was hailed as an assault on an American institution.  

Come on people, the nostalgia is nice and all, but this is about dollars and cents, not baseball and Mom's apple pie.  According to the NYSE February 8 earnings conference call, only 53% of its revenue was dollar denominated, while 47% was either pound or euro denominated.  It probably would have been closer to 50/50 if they didn't have to account for $19 million in unfavorable currency translations.  


Synergies and Survival

Both boards are expected to approve the deal this week; then it will be in the hands of the regulators.  Surprisingly, it might be European regulators who raise objections, since the combination of Deutsche Boerse and Euronext operations will effectively control nearly all European futures trading and may require separating the clearing and trading portions of the merged company.

Regardless of regulatory outcomes, it's worth taking a look at what is motivating the potential merger.  Exchanges worldwide have experienced margin pressures in the equities business as the advent of electronic exchanges has sliced execution costs to the bone.  For now, the futures and options business is where the money is, and the pot is growing.

According to the Options Clearing Corporation, average daily contract volume in options has grown from 5.9 million contracts per day in 2005 to 15.6 million contracts in 2010, while futures volume has increased from 22,600 contracts per day in 2005 to 105,600 contracts per day in 2010.  And 2011 is off to a rip roaring start at 18.9 million option contracts per day and 153,800 futures contracts per day.

As exchanges continue to move from floor based operations to electronic trading, volume is everything.  The few extra electrons it takes to send an additional order to an electronic exchange is minimal from the exchange's cost perspective, so the bigger the exchange, the greater the volume and the larger the margins.

Additionally, the combined exchange will offer previously unavailable ease of access to markets across the pond.  It is likely to become much less complex for the US investor to access European markets, and vice versa.  Again, another avenue for increasing volumes.

 The Deutsche Boerse is projecting synergies of $410 million from increased volumes and cost cutting in redundant divisions.


Who's Next?

You would think that this would be an easy question, since there are only four publically traded US exchanges: CBOE Holdings (CBOE), The CME Group (CME), The Intercontinental Exchange (ICE), and the Nasdaq OMX Group (NDAQ).  However, both Hong Kong and Tokyo have indicated that they would consider combinations, and the upstart BATS Exchange is not publicly traded.

BATS (Better Alternative Trading Systems), a Kansas based ECN, came into existence in 2005 and has since jumped to third in equity volume market share, behind the Nasdaq and NYSE, and its options business is growing strong.

Additionally, on the futures side, ELX Futures has been growing in the Eurodollar and interest rate space.  ELX was created in 2007 by a consortium including Bank of America, Barclays Capital, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan, Goldman Sachs and 5 others.

The table below provides a quick comparison between the publicly listed options and the current value of the NYSE.


What is striking is how far these stocks are from their all-time highs.  Even if the Deutsche/NYSE deal crests $40, it is still a far cry from its 2006 peak of $112.  And the CBOE, which went public in June 2010, has yet to recover its IPO price of $29.  This just goes to show what a tough business being an exchange is.  

Nevertheless, we have to look forward, and NDAQ certainly has the best earnings outlook and a very digestible market cap.  Additionally, the stock has been strong since the October announcement of the Singapore/ASX deal.  The market seems to have a lot of faith in this one.

The CBOE has held up rather well since the lock up expired in mid-December.  It is clearly the cheapest on the board, and could bring $3-$3.5 billion in the best case scenario.  Also the CBOE owns the VIX and other branded products, but mergers of late have been about synergies, volumes, and cost savings, and it's not clear what they offer on that front.  Notably, volume declined 2% in the most recent quarter compared to the year ago quarter.

The CME dominates the US futures markets, which makes it attractive, but its size might make it more of an acquirer rather that an acquiree.

Finally, the ICE is interesting, though not talked about as much.  The company beat estimates in last week's earnings release and is growing its presence as a credit derivatives clearing house.  Price wise it has held up well and management has a history of executing well.

There is no question that another tie-up or two in the exchange sector is likely on the horizon, but which players will be at the table is still up for discussion.

I am not recommending any of these stocks, but perhaps you now have a better starting point for your own due diligence.
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