QUALIPORT
London Stock Exchange: The Meaning Of LIFFE

By Maynard Paton (TMFMayn)
October 29, 2001

Rochester, Kent -- Qualiport watch list member London Stock Exchange (LSE: LSE) has been in the news of late. Competing alongside two of its European counterparts, the LSE is presently in bid talks with the London International Financial Futures and Options Exchange (LIFFE, pronounced 'life'). While the LSE, with or without LIFFE, will still remain a very attractive business, the three-way bidding battle suggests the winner will almost certainly overpay.

History

The recent history of LIFFE is very similar to that of the LSE. Increasing competition, driven by regulatory and technological changes, has meant both exchanges evolving into commercial, customer-driven businesses.

After its formation in 1982, the vast majority of the futures and options trading at LIFFE was conducted face to face. But in May 1998, following the installation of new management and their desire to keep the exchange competitive, LIFFE commenced the development of an electronic trading platform.

Since December 2000, all LIFFE's contracts have been traded through its new CONNECT system. Indeed, such is the functionality of the new platform, LIFFE is actively marketing it to other exchanges. Two notable customers are the Tokyo International Financial Futures Exchange (TIFFE) and the Nasdaq, through its Nasdaq LIFFE market.

Amidst the trading revolution, 1999 saw LIFFE effectively demutualise. LIFFE shares are currently traded on a restricted matched bargain basis.

Not surprisingly, the financial history of LIFFE is a somewhat complex affair. Following the transformation at the exchange, the resulting loss of trading floor rental income, the cost of the new IT system and a variety of restructuring charges have all dogged the accounts of late.

Year to 31st December      1998   1999   2000 
Turnover (£m)             139.0   84.6   88.6
Operating profit (£m)      11.9  (20.1)   2.8
Exceptional items (£m)    (80.6)  (8.1)   4.0
Net interest (£m)           9.1    6.1    5.3
Profit before tax (£m)    (59.6) (22.1)  12.2
Profit after tax (£m)     (57.8) (21.7)  14.6

During 2000, LIFFE reported pre-exceptional profits after tax of £10.6m, although this figure was boosted by a tax credit of £2.5m. What's more, interest received from LIFFE's cash hoard made up the bulk of that profit. However, LIFFE's most recent results do highlight the fruits of its past endeavours. In the first half of 2001, LIFFE's turnover rose 37% to £66m with pre-tax profits jumping 38% to £6.8m.

Beauty contest

At the moment, LIFFE is judging the merits of its three suitors -- the LSE, Deutsche Boerse and Euronext (the owner of the Paris, Amsterdam and Brussels stock exchanges). Although accurate details are thin on the ground at present, the price tag for LIFFE is said to be around the £550m mark.

Although LIFFE has an opaque financial record, it's not difficult to see the reputed £550m valuing the exchange to the full. The price tag will value LIFFE at some 52 times 2000 earnings, and assuming 40% earnings growth this year, represents a prospective price to earnings (P/E) ratio of 38. Remember too, that profits are currently being bolstered by tax credits and interest accrued from a £113m cash pile.

Assuming the rumoured valuation is true, why pay so much for LIFFE? The reasons are twofold: consolidation and synergy.

While stock exchanges have been domestic monopolies for years, the development of electronic trading is making the physical location of an exchange ever more redundant. In short, the type of financial instruments available, transaction costs and transaction efficiency are fast becoming the major competitive differences between one exchange and another.

Thus, the game's now on for stock exchanges to grab the widest range of trading products and the greatest economies of scale. LIFFE -- the second largest derivatives exchange in Europe with an IT system becoming accepted around the world -- makes a tasty morsel for those leading the consolidation fight.

Synergy

In terms of operational synergy, Deutsche Boerse and Euronext appear to be the obvious winners. But while Deutsche and Euronext already operate futures and derivatives exchanges, both have potential pitfalls to overcome.

For starters, there's bound to be competition concerns over any Deutsche bid, with the German exchange already owning Eurex, Europe's largest derivative exchange. Euronext's problems will probably stem from the inevitable IT integration. Its share dealing systems have failed seven times this year as technical issues have persisted on the three-way exchange.

However, the synergy benefits seem much more limited for the LSE. Firstly, it's not obvious that by buying LIFFE, it'll gain new customers for its own share dealing services. And secondly, there seems to be limited scope for cutting costs. The main expense for stock exchanges these days concerns IT. And it's certainly not easy to visualise any quick and easy integration of LSE's share-based SEQUENCE system with LIFFE's CONNECT platform.

Summary

Two other interested bidders, the fear of falling behind in a consolidation race, and few obvious synergies. The auction for LIFFE looks set to force the LSE to overpay for victory. And returns on LSE shareholders' equity will almost certainly suffer afterwards. Indeed, if the rumoured £550m valuation is accurate, the LSE will have to fund the purchase through debt and/or some sort of equity financing package.

All that said, an LSE and LIFFE combine would still be an attractive business for shareholders, even if the two exchanges operated as standalone subsidiaries. Prospective LSE/LIFFE shareholders, at the right price, could still see a healthy return on their investment. But any such investment would have to focus mainly on the LSE/LIFFE's enhanced industry position and "good value", rather than on "great management".

On the other hand, missing out on LIFFE wouldn't be the end of the world for the LSE. Should LIFFE reject all three bids, all investors are back to square one. Should LIFFE fall into the hands of a continental player, the LSE could become a takeover target itself.

After a steady trading update issued earlier this month, there's no reason to change the original entry price  ("the low 200s") set for a possible investment in the LSE. Depending on the costs associated with the consolidation race, and the distinct possibility of acquisition indigestion, there could be attractive opportunities to buy LSE shares in the future.

More: LSE discussion board | LSE website | LIFFE website | Danger -- Acquisition In Progress