Recommendation: BUY Target Price until 12/2015: $ 48.24 1. Reasons for the Recommendation Successful Change in Business Model Following the 2007-2008 financial crisis, stock market activity in the U.S. and Europe, measured by total average daily share volume traded, constantly declined. Meeting stronger competition in the cash equity business in the U.S. as well as in Europe, Nasdaq s total market share in the U.S. decreased by 34.36% from 2007 to Q2 2013. As a key driver of Nasdaq s transaction-based revenues, this strongly affected Nasdaq s revenue composition. In 2007, the U.S. cash equity trading business accounted for almost 75% of gross revenues, contributing a high of 25.11% to net revenues together with the European cash equity trading business in 2008. As of Q3 2013 U.S. cash equity revenues were down to 31.43% of gross revenues and the cash equity business in total contributed only 9.09% to total net revenues. 1 Facing a continuing difficult environment 2 Nasdaq was able to restructure its existing business model and shift towards a new form of business model based not solely on trading but also on trading-based information and market data. From generating almost 35% of net revenues through transactions in 2008, Nasdaq moved more towards a subscription-based revenue model, diversifying its revenue streams and hedging against bad market momentum. As a result, in Q3 2013, subscription-based revenues were up to 73% of total net revenues compared to 65% in 2008. Also margins increased significantly. While gross revenues have decreased by 11% since 2008, expected net revenues for 2013 have increased by 30% during the same time period. 3 In order to perform a change in their business model, Nasdaq s management successfully integrated acquisitions during the past few years, expanding their Technology Solutions (TS) segment mainly through the acquisition of BWise (2012) and Thomson Reuters Investor Relations, Public Relations and Multimedia Solutions businesses (2013). Following the acquisitions TS now accounts for an estimated annual revenue of $ 524 m and is expected to contribute approximately between 22% and 25% to total net revenues in 2014. In addition, the acquisition of Mergent s Index Business increased annualized revenues in the Information Services (IS) segment to $ 472 m, which includes Market Data and Index Licensing and Services. The IS segment now is expected to contribute around 20% to 23% to total net revenues. 4 When Nasdaq announced its Q3 results on October 23 rd, beating the market consensus by $ 0.04 per share, the stock price jumped from $ 33.58 to a high of $ 36.25 on October 24 th. 5 This is a clear sign the new business units and especially the potential for future revenues were not fully priced in at the time. With further integration of new business units, synergies, and continued improvements in operations, I believe the stock has far more potential than what is currently priced in. Within its Market Services (MS) segment, mainly consisting of transaction-related business, Nasdaq has shifted its revenue generation more towards the Derivative Trading and Clearing Services, capturing a strong market position to participate in the growing market of derivatives, especially in Europe. Out of the 1 Ratios calculated by analyst. 2 Nasdaq OMX, Earnings Conference Call Q3 2013, p. 2. 3 Ratios calculated by analyst. 4 Nasdaq OMX, Earnings Conference Call Q3 2013, p. 2 & 4. 5 Data from finance.yahoo.com. pg. 1!
27% total transaction-based revenues in 2013, two-thirds came from derivative-related transactions. This was also due to active expansions within the segment through acquisitions of NOS Clearing (2012), TOM (2013) and the start of a new London-based market for interest rate derivatives, which is expected to generate $ 150 m in additional revenues once its fully established. 6 With speculations about Nasdaq taking position in the bid-war over Euronext (currently NYSE), Nasdaq can further strengthen their position in Derivatives Trading and especially expand further into the central European market, which opens a significant opportunity for expanding revenues in Europe. Expansion of Market Services into US government bond trading Another important step for Nasdaq s future success was the June 2013 expansion of its Market Services (MS) segment into the US government bond trading business through the acquisition of espeed. espeed is one of the leading providers of electronic government bond trading with an expected annual revenue of $ 100 million. Nasdaq plans to implement significant software improvements to espeed s existing trading platform to gain further market share and customers by making espeed s trading system more compatible with its existing trading platforms. 7 Given the latest developments in the European economy and the recently reported record low inflation ratio in the Euro Union, Nasdaq has a good opportunity to increase its revenues in that business segment further. Considering an expected change in the European monetary policy, which implies lower interest rates on Euro denominated investments, as well as the expected tapering of the Fed s quantitative easing program, U.S. investments especially U.S. government Treasuries will become more attractive to investors. Currently, Nasdaq s annual revenue potential from U.S. bond trading is also very speculative ranging around espeed s pre-acquisition revenue of $ 100 million. I see further potential for Nasdaq to increase its revenues in this new business unit through its leading position in electronic based Treasury trading and the expectation of higher trading volumes in U.S. government debt. 8 Also, I believe the market has failed to price in this potential properly. Innovative New Products Alongside with the significant changes in its business model, Nasdaq has recently come up with innovative new products and ideas. On October 7 th Newfound Research LLC and Nasdaq OMX Global Indexes announced a partnership, combining Newfound s quantitative models and Nasdaq s brand and trading platforms to create new structured investment strategy solutions for institutional and retail customers. The new products consist of rule-based, outcome-oriented investment strategies, and tactical asset and risk-management indexes. With these new products I believe Nasdaq will be capable to further increase their Index Licensing and Services revenues, as well as strengthen their brand. 9 In addition, Nasdaq announced in October that they are working on a trading algorithm test facility, which will be capable of simulating all major U.S. equity exchanges. The partnership project with Thesys Technologies LLC is likely to launch in Q1 2014, providing Nasdaq s electronic trading customers the 6 Nasdaq OMX, Earnings Conference Call Q2 2013, p. 4. 7 Nasdaq OMX, Earnings Conference Call Q2 2013, p. 11 and Q3 2013, p. 9f. 8 http://online.wsj.com/news/articles/sb10001424052702304527504579171590348007248?keywords=euro+ Skids+from+2-year+high. 9 http://online.wsj.com/article/pr-co-20131007-908197.html. pg. 2!
opportunity to test algorithmic strategies with real historic market data in a safe environment. Such a testing facility will be a unique opportunity, especially for large institutional investors augmenting operational risk management efforts for the larger financial ecosystem. 10 Given a successful implementation of the testing facility, it will allow institutional investors to test automated (highfrequency) trading systems in advance. I see the potential to increase trading volumes and attract higher institutional trading activity on Nasdaq-operated trading platforms. After recent market outages caused by technology glitches, a successful launch of the project could reanimate investors trust in Nasdaq s technological expertise and strengthen its reputation as a solely computer-based and operated trading platform. Recurring Technology Glitches and Market Outages A problem Nasdaq is currently facing is the recurring technology glitches, which recently caused several trading halts on Nasdaq-operated markets. The problem was identified to be with the securities information processor (SIP), a computer, which includes all price quotes (bid, ask and final transaction prices) for all exchanges. After market outages in August and in the end of October, Nasdaq and NYSE announced on November 12 th that they have reached a broad agreement to work together to make markets more stable. According to a person familiar with the matter, the committees in charge of controlling consolidated data feeds for Nasdaq and NYSE are looking at ways to strengthen the internal backup systems for their respective streams. An agreement could also include a third party taking over operational control of both exchanges SIPs, as well as technology investment to increase the speed of the transmission of data by the SIPs. A more detailed statement by the exchanges committees is expected in the coming weeks. 11 The recent problems underline the difficulty of operating solely computer-based trading platforms, and expose Nasdaq to the risk of experiencing further technological glitches, which I think will be impossible to entirely prevent. New strong competitor from the merger of BATS & Direct Edge Nasdaq faces the problem of losing its second position in the trading industry, after BATS Global Markets and Direct Edge announced a completed merger deal in late August. The newly formed company will become the second largest exchange operator in the U.S. Representatives of both companies further announced that the merger will make them even more efficient, putting more pricing pressure on its rivals. 12 On the other hand, rumors prophecy a potential merger between Nasdaq OMX and the London Stock Exchange. At this point nothing is confirmed and both sides negate to be in any kind of talks with each other. 10 http://ecnandexchanges.banking-business-review.com/news/nasdaq-omx-and-thesys-introduce-trading-algorithmtest-facility-101013. 11 http://online.wsj.com/news/articles/sb10001424052702304243904579200411832432416. 12 http://dealbook.nytimes.com/2013/08/26/bats-and-direct-edge-to-merge-taking-on-older-rivals/?_r=0. pg. 3!
2. Company Analysis Strengths Besides the strengths mentioned in the previous section, which identifies Nasdaq s major strength as the shift to a more subscription-based revenue generation model, the company has several other strengths. In the Nordic and Baltic European market, Nasdaq has an almost exclusive overall leader position, covering markets in Sweden, Denmark, Finland, Estonia, Latvia, and Lithuania. Even though these markets are not comparable to the size of the U.S. or central European markets, they constitute constant revenue streams for Nasdaq. With ICE planning to spin off Euronext after the takeover of NYSE Euronext, Nasdaq is one of the major players in a bidding war for Euronext. A possible takeover of Euronext s business could create additional opportunities for Nasdaq to conquer market share in central Europe. On November 19 th the NDAQ stock jumped to $ 38.60 after opening at $ 37.00 following the news of Deutsche Börse not planning on making an offer for Euronext. In addition, Nasdaq s executive team is on the right track with the new business model not only making good decisions with its recent acquisitions but also proving its ability to integrate those acquisitions forming the new company structure. As the industry is likely to further consolidate, this could prove to be a strength opportunity for Nasdaq. Weaknesses The former strength of being the first company to provide a solely computer-based market platform now turns into one of Nasdaq s biggest weaknesses. Not only does the recent technology glitches and related market outages weaken the company. The failed Facebook IPO and the related pending legal investigations, as well as Twitter s recent decision to choose NYSE instead of Nasdaq, harm the company s reputation as a market for technology and IT companies. Finally, Nasdaq has been losing market share in cash equity trading for the last 5 years, which previously used to be its largest revenue source. Opportunities Nasdaq recently expanded its European derivatives segment to central Europe and the UK. With the NLX market, a London-based exchange for interest rate derivatives, Nasdaq took the first step to capture market share in the central European market and expand its brand. Furthermore, with the acquisition of 25% of TOM, a Dutch equities and equity derivatives venue, Nasdaq took an additional step towards central Europe. With the transaction, Nasdaq also acquired the right to purchase another 25.1% at a future date, which will open up the opportunity for further growth. Except from the fact that Nasdaq s growth is primarily driven by inorganic factors, it also continues a slow but constant organic growth of 4%. 13 Thus, a potential Euronext deal in the first half of 2014 can further strengthen Nasdaq s position in Europe. The expansion into the U.S. government bond trading market is also a major opportunity considering future changes in both the U.S. and European monetary policy. 13 Nasdaq OMX, Earnings Conference Call Q3 2013, p. 3. pg. 4!
Threats With the high concentration of technology and IT stocks trading on Nasdaq, I see a potential threat for the company, especially in the cash equity trading business. Recent discussions regarding a technology and IT bubble 2.0 could harm trading of those stocks and therefore threaten Nasdaq s operations significantly. Furthermore, the recently lost Twitter IPO could move more companies towards an IPO on other exchanges, especially due to the fact that consolidation in the industry brought up another strong technology-specialized competitor. pg. 5!
3. Industry Analysis Industry Summary The Stock & Commodity Exchange industry provides physical trading floors or electronic marketplaces to arrange trades in securities, commodities and related contracts between sellers and buyers. 14 Therefore, the industry plays an essential role in the financial system, ensuring liquidity and tradable quotes for all kinds of securities. In addition, Nasdaq generates a large portion of its revenues through Market Data and Information Services, based on the information provided through its market operating activities. Competition A high level of competition characterizes the Stock & Commodity Exchange industry. After the recent M&A activities, four competitors dominate the industry: NYSE Euronext, CME Group, Nasdaq OMX Group, and the new-formed BATS Global Markets (including Direct Edge). The largest participant in the industry is NYSE Euronext, which hosts about 22.5% of all stock trading in the U.S. After the merger with Direct Edge, BATS Global markets will approximately reach a market share of 20.5%. As a result, the former number two, Nasdaq OMX, will be pushed to third place, servicing 17.5% of the market. 15 Also, the industry is experiencing further competition through alternative trading systems and dark liquidity pools run by investment banks. These almost unregulated trading conglomerates are used by institutional investors to execute large transactions, and avoid the lit markets, which dilutes securities quotes. To the relief of many market providers, the SEC recently announced to review the regulatory guidelines for dark pools, holding out the prospect of stronger regulations. Industry Outlook All things considered, the industry is expected to grow, even though the growth rate will be lower than the period from 2008-2013. IBISWorld projects the overall industry revenue to increase by an annual rate of 5.4 % to a total amount of $16.1 billion in 2018. Higher trading volumes in commodities and derivatives will fundamentally drive this growth. On the other hand new regulations, especially in the OTC market for derivatives, as well as higher collateral requirements for trades, will decrease margins all over the industry, slowing net revenue growth. Regardless, a higher level of regulation is expected to bring back trust in the markets and therefore also increase trading volumes in the long-term. Economies of scale will become more important in the future. To split high fixed costs and stay competitive compared to alternative trading systems, exchanges are likely to do more acquisitions of domestic derivatives and commodities markets, which will lead to further consolidation in the market. With further increasing technology standards and possibilities, new worldwide trading platforms, which allow investors to trade over all asset classes, time zones and geographic boundaries, are likely to occur in the foreseeable future. NYSE Euronext is expected to complete such a platform in 2013, while Nasdaq OMX is working on expanding their European trading platform to compete with the NYSE Euronext venture. 14 http://clients1.ibisworld.com.libproxy.unm.edu/reports/us/industry/default.aspx?entid=1312. 15 http://dealbook.nytimes.com/2013/08/26/bats-and-direct-edge-to-merge-taking-on-older-rivals/?_r=0. pg. 6!
Appendix 1: Inputs into valuation using multiples 2007 2008 2009 2010 2011 2012 2013F 2014F 2015F 2016F AVE Stock Price (Q4) 43.96 25.70 19.55 21.72 25.02 23.97 36.97 43.32 48.24 Diluted EPS 3.46 1.58 1.55 1.92 2.20 2.06 2.15 3.15 3.58 3.89 Sales 2437 3649 3351 3197 3435 3117 3225 3520 3797 4030 Shares Outst. (Diluted) 154000000 214100000 204000000 200000000 180000000 169100000 170142974 170142974 170142974 170142974 Sales per Share 15.82 17.05 16.43 15.99 19.08 18.43 18.95 20.69 22.31 23.69 P/E (1-Y TRAILING) 12.70 16.27 12.61 11.32 11.37 11.64 17.20 13.75 13.47 P/S (1-Y TRAILING) 2.78 1.51 1.19 1.36 1.31 1.30 1.95 2.09 2.16 P/E (1-Y FORWARD) 27.82 16.58 10.18 9.87 12.14 11.15 11.74 12.10 12.40 P/S (1-Y FORWARD) 2.58 1.56 1.22 1.14 1.36 1.26 1.79 1.94 2.04 Analyst's own calculations. Source of basic data: company's 10-K; Yahoo! Finance Appendix 2: Revenue Composition Market Services Listing Services Information Services Technology Solutions Gross Revenue 61.98% 7.08% 14.66% 16.27% Net Revenue 39.53% 11.26% 23.32% 25.89% Appendix 3: Common-sized Income Statement 2012 2013F 2014F 2015F 2016F Gross Revenue 100% 100% 100% 100% 100% - COGS 46.66% 41.16% 37.40% 36.36% 35.92% = Net Revenue 53.34% 58.84% 62.60% 63.64% 64.08% - Operating Expenses 31.20% 37.74% 34.44% 34.47% 34.49% = Operating Income 22.14% 21.11% 28.16% 29.17% 29.59% - Non-Operating expenses 4.55% 4.31% 5.28% 4.92% 4.65% = Net Income 11.21% 11.19% 15.20% 16.11% 16.57% pg. 7!