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QUALIPORT
By
Rochester, Kent – On Thursday, I gave advance notice of adding company number 16 to the Qualiport's watch list. The mystery company is the London Stock Exchange (LSE: LSE), the fundamental investment characteristics of which are superb. The LSE is a straightforward and visible operation, holds a domestic monopoly and should directly benefit from the long-term trends of increased share trading volumes and equity investment in general. History and rivals Currently valued at £1b, the LSE is one of the world's leading equity exchanges and facilitates the raising of capital and the trading of shares. The LSE has 98% of all UK listed companies on its exchange with more than 99% of all UK trades (by value) going through its books. After 200 years as a quasi-mutual, the LSE floated last year. Its shares were initially traded on a restricted matched bargain basis, but earlier this month, the company's shares moved to its own main market. Underpinning the LSE's demutualisation was the "greater access to capital, which should provide the necessary strategic flexibility to play a leading role in the development of global capital markets". The general liberalisation of financial markets, combined with various technological advances, is increasing competition amongst stock exchanges. For the LSE, other quoted rivals include Deutsche Boerse, Euronext (a combination of the Amsterdam, Brussels and Paris exchanges) and OM (owner of the Stockholm exchange). Pan-European start-ups, such as the AIM-listed Virt-X (LSE: VTX) and Easdaq, or aggressive US players, notably the Nasdaq exchange, are also ones to watch in what is expected to be gradually consolidating industry. However, the LSE looks to be well placed for the corporate get-togethers ahead. It's the largest exchange in Europe in terms of the numbers of companies listed and of their total market capitalisation. Indeed, the LSE was subject to an ultimately unsuccessful hostile bid from OM last year. On this point, it's also worth noting that the move to become fully listed has removed the 4.9% limit on ownership the LSE previously had in place. The business The LSE's revenues are generated from three areas: * Company services (17% of group revenues): Primarily the fees charged for the admission of a company's shares to the stock exchange, relating to both flotations and rights issues, as well as annual listing charges. * Trading Services (34% of group revenues): Predominantly the charges levied against every trade made through the LSE's electronic order book or reported to the Exchange for subsequent publication to the market. * Information Services (46% of group revenues): Largely the income generated by the sale of real-time and historic share price data to either direct market participants or third-party information suppliers (e.g. Reuters (LSE: RTR)). The financials Here's the five-year LSE financial record. (to 31st March) 1997 1998 1999 2000 2001
(£m) (£m) (£m) (£m) (£m)
Turnover
-- Company Services 19.3 21.0 23.1 25.7 31.9
-- Trading Services 38.9 39.1 40.5 54.1 64.2
-- Information Services 62.5 64.7 71.8 72.9 85.3
-- Other 4.8 5.9 6.9 6.8 5.8
-- Discontinued 66.0 12.4 12.0 11.7 1.2
Total 191.5 143.1 155.3 171.2 188.4
Operating Profit
-- Company, Trading and
Information Services 4.4 23.3 21.0 41.8 57.9
-- Discontinued 34.5 6.2 6.7 5.2 0.8
Total 38.9 29.5 27.7 47.0 58.7
Exceptional Items (24.8) (23.0) (20.6) (5.1) (18.9)
Reported Earnings 24.4 15.4 11.0 32.1 15.2
Although without recourse to acquisition, the LSE's performance isn't straightforward. The discontinuation of a regulatory role and its own settlement service cloud the total turnover record. However, on a continuing basis, revenues have risen steadily from £126m to £187m since 1997.
In terms of operating costs, a somewhat unprecedented level of IT development (including the introduction of SEQUENCE and CREST systems) hampered profits in 1997. It's also worth noting the recent sharp up-turn in operating profits. Since 1999, operating profits have jumped from £21m to £58m, in which time total revenues increased from £155m to £188m. It appears the LSE has a high operational gearing, with revenues above a certain point going straight through to the bottom line. Operating margins were a staggering 31% in 2001.
The myriad of exceptional charges over years confuses matters too. Never a year has gone recently without either a property charge, a rebate to members, some Euro/Y2K system costs or fees related to aborted bids and mergers.
Cash flow
A quick check on the two key cash flow factors – working capital and capital expenditure – implies that accounting profits are largely reflected in cash.
(to 31st March) 1997 1998 1999 2000 2001
(£m) (£m) (£m) (£m) (£m)
Operating Profit 38.9 29.5 27.7 47.0 58.7Working capital change 28.9 9.9 (3.3) (16.1) (4.5)
Depreciation 18.3 14.7 33.1 22.2 19.9 Capital Expenditure (6.2) (9.6) (25.6) (14.7) (22.7)There's little in the way of cash being continually absorbed into working capital, while the depreciation charge in the profit and loss account isn't understating cash capital expenditure.
Given the discontinuing businesses and exceptional items, calculating an incremental return on equity figure is a complex and probably academic task. On a traditional basis, using pre-exceptional 2001 earnings of £45m, and a year-end equity base of £242m, the LSE's return on equity comes to healthy 18.6%. That calculation, plus the fact that the LSE has £150m cash in the bank, no debt, low working capital requirements and fixed assets (i.e. mostly buildings and offices) not directly related to the expansion of its business, leads me to believe the LSE is a business that can reinvest its future profits at a superior rate of return.
Summary and Valuation
The LSE has many very attractive investment traits. In short, it's a legalised monopoly – a shareholder's dream. While rival exchanges will gradually nibble away at its market, I've no doubt that the LSE will remain the predominant UK operator for some time. Indeed, the LSE states: "[Because] of continuing differences in law and regulations that inhibit competition, a fully competitive environment amongst European exchanges is dependent on moves towards a single financial services market."
Other key features include the provision of recurring "must-have" services (notably share price data) and being one of the most visible investments around for the ordinary shareholder. As April last year showed, everybody knows when there's a problem at the LSE.
Apart from the long-term upward trend of trading volumes, growth should also come from fee increases. Recent reports suggest there's some headroom in raising the LSE's charges to those of comparable exchanges. There's no doubt the LSE's change from being a cosy mutual will inspire a greater commercial awareness.
Of course, there are risks. Firstly, the LSE is highly dependent on stock market activity. The above financial performance has been largely accomplished with the help of a raging bull market. With high operational gearing, a prolonged downturn in trading will see pressure on profits.
And secondly, there is a management issue. The present LSE Chief Executive, Clara Furse, has been in the job for just six months. Her record is unproven. However, unlike most other businesses, having talented management is not mandatory at a monopoly. The LSE has been through a number of Chief Executives in recent years, but the company has still fared well.
At 339.5p, and taking reported earnings as free cash, LSE shares presently offer a free cash flow yield of 4.8%. Undoubtedly, the group's very attractive fundamentals and some sort of "bid expectation" are currently built into the valuation. Overall, should the shares fall to the low 200s, equating to a free cash flow yield of 7-8%, the Qualiport would be a buyer.
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