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QUALIPORT
By
The fundamental investment characteristics of the London Stock Exchange (LSE: LSE) are superb. It's 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. The Qualiport watch list member issued its annual results last week and the company's underlying attractions shined during a weak period for the stock market. (For those unfamiliar with the LSE, background information can be found here and here). The financials Here's the five-year LSE financial record.(to 31st March) 1998 1999 2000 2001 2002
Turnover (£m) 143.1 155.3 171.2 188.4 206.6
Operating Profit (£m) 29.5 27.7 47.0 58.7 70.5
Exceptional Items (£m) (23.0) (20.6) (5.1) (18.9) (3.6)
Pre-tax Profit (£m) 20.5 18.1 48.5 30.4 75.2
Reported Earnings (£m) 15.4 11.0 32.1 15.2 49.9
Earnings per share (p)* - - - 15.2 18.3
Dividend per share (p) - - - 3.2 3.6
Even though the past year was generally one to forget for the stock market, the LSE's recent annual results showed robust progress. That said, the LSE's three operational divisions experienced differing performances.
* Information Services: 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)).
Although there were 2,000 fewer computer terminals directly receiving Exchange data during the year, the remaining 105,000 helped increase divisional revenues by 9% to £95m.
* Broker Services: Predominantly the charges levied against every trade made through the LSE's electronic order book or reported to the LSE for subsequent publication to the market.
In the past twelve months, the total number of equity bargains increased by 25% to a daily average of 200,000. The daily average number going through the LSE's own SETS system surged 86% to 69,000. The greater trading volumes sent this division's revenues 26% higher to £81m.
* Issuer services: 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.
Weak market conditions inspired just 289 flotations during the year to March 2002, a figure 39% lower than the number recorded in the previous twelve months. Revenues here slipped 16% to £27m.
Cash flow
Overall, net turnover rose 11% to £207m while operating profits jumped 20% to £71m. Operating margins remained healthy, improving from 31% to 34%. Furthermore, the latest results reaffirmed the LSE's low appetite for working capital and capital expenditure.
(to 31st March) 1998 1999 2000 2001 2002
Operating Profit (£m) 29.5 27.7 47.0 58.7 70.5
Working capital change (£m) 9.9 (3.3) (16.1) (4.5) (4.0)
Depreciation (£m) 14.7 33.1 22.2 19.9 17.5There's little in the way of cash being absorbed into working capital, while the depreciation charge isn't understating cash capital expenditure. Having squirreled away another £43m in the year, it's worth noting the LSE now has £190m in the bank.
Capital Expenditure (£m) (9.6) (25.6) (14.7) (22.7) (15.8)
Calculating the LSE's incremental return on equity performance is a complex and largely academic task. Since 1996, the LSE has suffered numerous exceptional charges, discontinued its settlement and regulatory businesses and experienced somewhat unprecedented IT costs to develop the SEQUENCE and CREST systems.
On a traditional basis, using pre-exceptional 2002 earnings of £53m and a year-end equity base of £281m, the LSE's return on equity comes to a sound 19.0%. That calculation, plus the fact that the LSE has a substantial (and inherently low return) cash pile, no debt, low working capital requirements and fixed assets (i.e. mostly buildings and offices) not directly related to the expansion of its business, implies the LSE can reinvest its future profits at superior rates of return.
Valuation and Summary
Excluding interest income, the latest results showed the LSE producing free cash of 16.8p per share. After subtracting the 64.6p per share cash pile from the present 477.5p share price, LSE shares offer a historic free cash flow yield of 4.1%. Even if free cash expands by a racy 15% to 19.3p per share in the current year, the shares would stand on a prospective free cash flow yield of 4.7%. On that growth assumption, 322p per share would offer a forward free cash flow yield of 7.5%.
The lack of 'obvious value' in the LSE's shares is no doubt due to the Exchange being the centre of much merger and acquisition speculation.
The general liberalisation of financial markets, combined with various technological advances, is increasing competition amongst stock exchanges. In the past two years, the LSE has announced -- and withdrawn from -- a merger with Deutsche Boerse, fended off a bid from OM (owner of the Stockholm exchange) and lost out to Euronext (a combination of the Amsterdam, Brussels and Paris exchanges) in a three-way auction for LIFFE.
In addition, the LSE recently admitted to being in discussions with "various other parties" as part of its "ongoing review of strategic options". The Nasdaq exchange has been the popular choice amongst the City rumourmongers. But whatever happens, the LSE looks to be well placed for the corporate get-togethers ahead.
While there was no word on potential partners in the latest results, the only real shareholder danger surrounding the LSE is a value-destroying acquisition. It should be remembered that the LSE was willing to pay a very generous £550m for LIFFE (valuing the futures exchange at around 40 times earnings) for (seemingly) limited cross-selling opportunities and IT system synergies.
London Stock Exchange: A Shareholder's Dream | London Stock Exchange: The Meaning Of LIFFE | London Stock Exchange discussion board