Nasdaq is a leading provider of trading services, securities listing and market information products — the company has a unique, diversified business mix. The Nasdaq Stock Market is the largest global equity securities market measured by listed companies and daily trading volumes by shares. Nasdaq also maintains leadership in the listings business with over 60% IPO market share last year. Since new management arrived in 2003, the company has embarked on a multiyear restructuring campaign to improve profitability and maintain and/or build market share in its core product set.
Given Nasdaq’s favorable brand and pricing proposition, high barriers to entry, and recurring fee nature of listings revenues, I see growth in Nasdaq’s listings business as key to garner a premium valuation over time. However, the lack of a more visible listing fee pipeline (due to future market stresses) could further intensify pressure on long-term earnings growth. Measured by dollar volume, total U.S. equity trading volumes (NYSE and Nasdaq combined) have grown almost ten-fold since 1990, and I expect this trend to continue. On a shares-traded basis, volume has grown at an almost equally impressive 8.4 times 1990 average volumes. U.S. equity trading volumes last peaked in 2000, largely driven by the exuberant, technology-infused equity market environment (especially evident in Nasdaq volumes). Compared with 2000, U.S. dollar volumes are still 41% below peak levels while average shares traded are roughly 15% below peak levels.
Nasdaq OMX has two main areas of business
1) Market Services (55% of estimated 2011 revenues)
Nasdaq’s Market Services business segment is comprised of the transaction and execution and market data businesses. Market Services includes the operations of the Nasdaq Market Center, an all-electronic marketplace that facilitates trading in over 7,800 equity securities (Nasdaq, NYSE and other OTC-listed securities) with over 230 market makers.
Nasdaq’s purely electronic trading system maintains a clear competitive advantage over traditional open-outcry markets via its delivery of faster trade execution, tighter bid-ask spreads, and fewer trading errors.
Issuer Services (45% of estimated 2011 revenues)
Issuer Services consists of Nasdaq’s Corporate Client Group and Financial Products revenues. The Corporate Client Group is responsible for managing new corporate listings on the Nasdaq Stock Market and providing its client base with various customer services (i.e., insurance, corporate governance) and information products. Revenues are largely comprised of issuer fees (initial fee, additional shares fee and annual listing fee). Nasdaq commands a dominant market share in the listings business — the Nasdaq Stock Market completed 62% of all domestic IPOs in 2011.
Issuer Services also houses the company’s Financial Products business. Here, the company garners fees by licensing the right to use Nasdaq-sponsored financial products (i.e., QQQ, Nasdaq Biotechnology Index). ETFs and index products have gained tremendous popularity and exhibited robust growth during recent years. In addition, Nasdaq operates The PORTAL Market, a marketplace for securities sold in private placement offerings and eligible for resale under SEC Rule 144A.
I read the latest second-quarter results and noted they were really solid, underlining the simplicity and resilience of their business model, as earnings per share grew to another record high. In the earnings call, management said NDAQ achieved double-digit growth in net revenues during a time when ongoing economic uncertainty has created a challenging environment for many of our volume-related businesses.
It is encouraging to see that they have a revenue goal of generating a three-year compounded average growth rate of 9%, while maintaining comps and operating margins.
Some specific positives:
a) Nasdaq OMX has been improving U.S. cash equities volumes dramatically. U.S. consolidated cash equity volumes averaged 8.8 billion shares per day during the third quarter, up 16% from year ago levels and up 22% from second quarter levels as the spike in volatility benefited trends here — increased ETF activity drove most of the improvement
Considering a 2011 EPS of $2.3 and assuming a 6% growth (which is conservative), the shares can trade at 28, a 10% upside from current levels.
b) Consolidated U.S. options volumes remain strong. During the third quarter, overall volumes in multi-listed equity and ETF options averaged 18.5 million contracts per day, a new record for the company (+48% yr/yr, +17% qtr/qtr).
c) Market share near record levels. During the third quarter, NASDAQ’s share in non-proprietary multi-listed products averaged 26%, down from a record 29%. This shows that the company is on the right track.
d) Management committed to reduce debt and reward shareholders: As of June 30, NASDAQ OMX held $2.2 billion of debt on its balance sheet, implying a current debt-to-EBITDA ratio of 2.6x. In late September, the company announced that it had refinanced $450 million of debt outstanding under its existing bank credit facility (termed out from 2013 to 2016). In addition, the firm has also offered to tender for all its 2.50% convertible senior notes outstanding ($428 aggregate principal amount, offered to purchase at a 2.5% premium to face value). The tender will be financed through cash on hand as well as incremental borrowing under the bank credit facility. NASDAQ OMX will use this opportunity to further delever its balance sheet.
I see NASDAQ OMX as a Buffett-like moat, simple business that is managed by proved and competent management shares. Large positives are the management’s track record of execution and the very encouraging deleveraging.
Considering a 2011 EPS of $2.3 and assuming a 6% growth (which is conservative considering historical growth ratios and management projections), the shares can trade at $28, a 10% upside from current levels and near 2011 highs.
Given that there is not too much upside from buying the shares directly, I consider NDAQ a good candidate for a covered call strategy, collecting premiums from selling above 28 calls.