Nasdaq Transformation Still Has A Ways To Go To Reach Peer Valuations

For a stock that was essentially dead money for five years, The NASDAQ OMX Group (NDAQ) has surprised a lot of investors over the last year. After struggling to capture the interest and attention of investors for a long time, the company (and its peers) have got very exciting about the same time that IntercontinentalExchange, Inc. (ICE) started looking at buying the NYSE. NDAQ of course is the owner of the eponymous exchange, which is one of the big two in the US. Virtually everyone reading this presumably knows that, and most people are probably equally aware of the issues that have challenged the Nasdaq over the last couple of years from the embarrassing farce of Facebook's debut, to the lack luster retailer participation and the controversy surrounding trading glitches and high frequency traders on the market.

Yet for all of these challenges, NDAQ's stock has essentially doubled over the last year as investors have embraced a new international strategy of partnering with other firms, and the slow but inexorable transition of the firm from a public exchange company to a true financial technology company. This year, 70-75% of Nasdaq's revenues will probably come from non-trading revenues.

Despite these improvements though, NDAQ is still best known as the owner of the NASDAQ, and here business is not that great. Cash equities revenues continue to struggle versus expectations and historical norms, and I don't see this reversing in the near future. So as far as NDAQ has come, its transition is still incomplete. Shareholders may have rewarded the company so far, but its valuation still sits roughly 35% below a basket of peers and well below the multiple of industry leaders like ICE. Thus if NDAQ is able to continue improving its operations and profits, despite some of the challenges facing the legacy cash equities business, I think in time the stock could re-rate at a higher multiple.

The company once known as The Nasdaq Stock Market, Inc. today operates three different segments: Market Services, Issuer Services, and Market Technology. The Market Services segment includes the company's market data and broker services business and the transactions services business. It operates the NASDAQ stock market in the US and the NASDAQ OMX in Europe offering trading in equities, bonds, structured products, commodities, ETFs, and derivatives in various European markets. These other trading segments are highly important as cash equities trading volumes have been lower for the last couple of years, while virtually all derivatives and other exotic securities have seen significant trading volume increases. Given this backdrop, it's not surprising to me that NDAQ seems focused on growing its derivatives business. The firm is doing this through a variety of mechanisms including acquisitions and partnerships. For example, last July, the company acquired eSpeed from BGC Partners for $750 million, plus $484 million in stock earn-outs. eSpeed's business focuses on electronic trading of fixed income products, primarily various Treasury securities. The focus that NDAQ has been putting on getting into other areas, which offer both better growth and fatter spreads suggest management thinks this is where the future of the firm lies. The recent announcement that the firm would like to get involved in limited levels of stock trading for private corporations (e.g. to help facilitate employee stock trading) is also indicative of this trend.

NDAQ's Issuer Services group provides capital raising support to companies around the world, as well as developing NASDAQ branded indexes and associated derivative and alternative financial products such as the NASDAQ-100 Index. Remarkably, these indices are the basis for almost 2,000 different structured products around the world. Finally, the company is also a tech solutions provider for other exchanges, clearing organizations, etc. Here the company offers trading, listings, clearing, market data, etc. to a variety of client organizations around the globe.

These non-cash equities business are playing a critical role in the significant EPS appreciation that NDAQ has seen in recent years. I expect the firm to earn ~$3 a share this year based on the growth in its non-equity trading businesses and its eSpeed and investor relations unit acquisition from Thomson Reuters (TRI). The investor relations unit is particularly critical to helping NDAQ maximize its revenues from stable recurring subscription products. While these two deals both carry an element of integration risk for NDAQ particularly since they are areas where the firm does not have a lot of past experience, so far the merger integrations seem to be going well based on recent management commentary.

Revenue (Million $)	1Q	2Q	3Q	4Q	Year
2013	744	814	805	849	3,211
2012	801	823	743	752	3,119
2011	817	838	946	839	3,438
2010	771	886	758	783	3,197
2009	895	889	810	815	3,409
2008	813.8	821.5	990.3	1,024	3,649
EPS	1Q	2Q	3Q	4Q	Year
2013	0.25	0.52	0.66	0.81	2.25
2012	0.48	0.53	0.52	0.5	2.04
2011	0.57	0.51	0.61	0.45	2.15
2010	0.28	0.46	0.5	0.69	1.91
2009	0.44	0.33	0.28	0.2	1.25
2008	0.69	0.48	0.28	0.17	1.56

NDAQ's revenues are still well below where they were a few years ago in 2008 and 2009, even though earnings have rebounded. The double-digit revenue growth in 2013 helps of course, but the key to keeping this trend up in 2014 (where I'm forecasting nearly 18% revenue growth), is improving execution and capturing revenues in the non-transactions businesses. A rebound in trading volumes will help of course, but I'm not sure this is in the cards. It's been five years since the Recession, and volumes have been fairly anemic that entire time. At some point, one has to simply recognize that may be the world has changed and that adjusted trading volumes are not going to go back to a pre-Recession "normal." Fortunately for shareholders, the non-trading businesses are picking up a lot of this slack and should be poised for very solid double-digit growth this year.

One key issue that investor should watch out for this year is any inflection in trading revenues and market share. That could change if the platform gets better traction, which could happen under management's initiative to put in place an improved faster matching engine. I'm not as optimistic about NASDAQ private market (which I alluded to earlier), given the struggles of SharePost and Second Market in the space. That said, I will confess that NASDAQ certainly has much more brand cache than its private competitors. Thus to the extent that privately held companies see doing business with NDAQ as a ramp to growing and eventually going public, the Private Market initiative could end up being a good growth engine in time. For now, shareholders will have to be satisfied with new acquisitions, and the fairly high likelihood of renewed share buybacks later in the year. On the whole though, NDAQ is doing a nice job of going from a lethargic company with little of innovativeness to a firm that investors can get excited about.

Source: Nasdaq Transformation Still Has A Ways To Go To Reach Peer Valuations

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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. (More...)

Seeking Alpha PRO helps fund managers:

• Research new investment ideas


• Reduce risk

Find out if PRO is right for you:

Thank you for your interest in Seeking Alpha PRO

We look forward to contacting you shortly for a conversation.

This entry passed through the Full-Text RSS service — if this is your content and you're reading it on someone else's site, please read the FAQ at http://ift.tt/jcXqJW.