QUALIPORT
Profiting From The Bear Market

By Maynard Paton (TMFMayn)
November 7, 2002

The London Stock Exchange (LSE: LSE) is a wonderful business. 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.

During what was another difficult period for the stock market, today's interim results from the Qualiport watch list member showed very good progress. (Before getting down to the results nitty-gritty, those unfamiliar with the LSE can swot up here, here and here.)

Interim figures

Here's a summary of the LSE's six-month performance:

Six months to September 30th         2002            2001

Turnover (£m)                       113.9           102.6
Operating profit (£m)                40.5            34.2
Pre-tax profit (£m)                  47.4            34.9

Earnings per share (p)               10.5             9.0
Dividend per share (p)                1.3             1.1

All three of the LSE's divisions contributed to the financial improvement.

Turnover from Issuer Services (fees from flotations, rights issues and listings) jumped 39% to £19.2m, the primary driver being a rather large increase to the Exchange's annual listing fee. Meanwhile, Broker Services (charges on trades made via the LSE) saw sales increase 10% to £43.7m as greater trading volumes on the SETS electronic order book were recorded.

Information Services (data supply and the Regulatory News Service) witnessed a 7% rise in revenues to £50.7m. The start of the commercially-minded RNS service did the business here. The top-line performances all combined to drive group operating profits, earnings per share and the dividend 17-18% higher.

Today's results also showed the LSE maintaining its inherently attractive accounts. Operating margins are now a whopping 36%, working capital requirements remained negligible and gross fixed asset expenditure was less than the depreciation charge. The LSE's cash pile was £237m (about 80p per share) at the end of September, up from £189m six months prior.

In terms of valuation, the LSE generated free cash of 18.3p per share over the twelve months to September 2002. Add on the 80p per share cash pile and investors who demand a historic 7.5% free cash flow yield require an entry share price of 324p.

Market position

The LSE's appealing finances stem from its monopoly on UK share trading. (At present, about 99% of domestic volumes are performed via the Exchange.) But can the LSE remain the dominant player? There are two areas that help limit competition:

* Regulation: The Financial Services Authority supervises the running of domestic stock exchanges. To become a 'Recognised Investment Exchange', various operational conditions of the Financial Services and Markets Act 200 have to be met, not least those concerning investor protection, ensuring orderly trading and maintaining generally high standards of business integrity. The regulatory environment is not an insurmountable barrier, but a significant hurdle that potential new entrants must take seriously.

* Liquidity: Exchanges need plenty of buyers and sellers to create an efficient marketplace. As such, new entrants face the age-old problem of tempting traders away from an established exchange. Even though transactions may be cheaper and more efficient elsewhere, there's little point in switching exchanges if nobody will be available to complete your proposed trade. A Catch-22 situation can arise, with market participants waiting for sufficient numbers to migrate to the new exchange before joining themselves.

Virt-x

Investors need look no further than Virt-x (LSE: VTX), formerly known as Tradepoint Financial Services, to determine the inherent strength of the LSE. The Tradepoint Investment Exchange began life in September 1996 and became the LSE's first domestic rival in nearly 200 years.

Although promising lower dealing costs, greater trading efficiency and the first pan-European exchange, Tradepoint never really got off the ground. The start-up was continually in the red and, following one or two funding dramas, was effectively rescued by the SWX Swiss Stock Exchange in 2000. Even with substantial Swiss trading volumes, the renamed Virt-x continues to lose money.

The following table, covering the top four London shares traded on Virt-x during September, highlights the LSE's clear dominance over its smaller rival:

September 2002

Share                Value of trades (£m)     Number of Trades
                       Virt-x     LSE           Virt-x   LSE

Vodafone                285     8,931            386    88,359
BP                       80     8,480            192    81,142
HSBC                     72     7,639            107    66,547
Northern Rock            43       557             31    16,132

So after seven years in operation, Virt-x has still barely scratched the surface.

Of course, other exchanges have sprung up in recent years to tempt UK companies away from the LSE. However, no great threat has materialised.

OFEX has quickly become an established matched-bargain exchange for smaller companies. It has 100 or so listed companies, of which 79 are presently valued under £10m. There's also Easdaq, a sort of European Nasdaq, which still has 41 businesses (many of which are troubled technology firms) on its books. Many Easdaq companies, such as Autonomy (LSE: AU.), also list their shares on the LSE.

Although new markets have entered the fray, the LSE has not stood still. The Alternative Investment Market, dedicated primarily to smaller companies, was created in 1996. There's also the LSE's techMARK market, formed in 1999, which specialises in fledgling technology companies. It's fair to say the LSE could compete with any niche exchange by simply creating a new sub-market of its own.

Summary

Overall, the LSE's major rivals remain, as ever, the world's other major bourses. But thankfully, investors should not expect a long-term bloodbath. Consolidation among the leading exchanges is widely anticipated.

Indeed, over the past two years, the LSE has announced -- and aborted -- 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. There have also been unconfirmed talks with the US Nasdaq exchange, too.

While not exactly cosy, having the same old foreign rivals as its main opponents should keep the LSE's enticing finances in order for some time to come. The real danger for LSE shareholders is not one of losing its competitive edge, but one of indulging in daft corporate activity.

More: A Share For All Markets (Annual Results 2002) | London Stock Exchange: A Shareholder's Dream | The Meaning Of Liffe