QUALIPORT
A Share For Bulls And Bears

By Maynard Paton (TMFMayn)
May 15, 2003

Few companies can better the buy and hold characteristics of the London Stock Exchange (LSE: LSE). It's a straightforward, predictable and visible operation, holds a domestic monopoly and has genuine long-term growth prospects. Though investors remain gripped by the bear market, preliminary results out today showed the Exchange continuing to prosper.

(For those unfamiliar with the LSE, refreshers on the investment attractions can be found here, here, here and here.)

Results

The table below shows the LSE's five-year financial record:

Year to 31st March          1999     2000     2001     2002     2003

Turnover (£m)              155.3    171.2    188.4    206.6    225.9
Operating Profit (£m)       27.7     47.0     58.7     70.5     81.7
Exceptional Items (£m)     (20.6)    (5.1)   (18.9)    (3.6)   (11.6)
Pre-tax Profit (£m)         18.1     48.5     30.4     75.2     79.6

Earnings per share*(p)         -        -     15.2     18.3     20.9
Dividend per share (p)         -        -      3.2      3.6      4.3

(*Before exceptional items. All figures adjusted for goodwill)

In year ending March 2003, turnover increased 9% to £237m and underlying operating profits jumped 16% to £82m. Margins continue to improve, moving up from 34% to a wonderful 36%. There was another round of exceptional items, this time a £10m VAT refund and a £22m provision on the Exchange's new residence. The dividend was raised 19% to 4.3p per share.

The LSE's three main divisions all made progress:

* Information Services: Largely the income generated by the sale of real-time and historic share price data to direct market participants and third-party information suppliers (e.g. Reuters (LSE: RTR)).

Although 11,000 fewer computer terminals were receiving direct Exchange data at the year end, the remaining 94,000 helped divisional revenues increase 8% to £102m. Issuing statements on behalf of 90% of the FTSE 100, the Regulatory News Service generated turnover of nearly £7m.

* 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 8% to a daily average of 215,000. The daily average number going through the LSE's own (higher margin) SETS system surged 58% to 109,000. The greater trading volumes pushed this division's revenues 8% higher to £87m.

* Issuer services: Primarily the fees charged for the admission of a company's shares to the Exchange, covering both flotations and rights issues, as well as annual listing charges.

A rise in tariffs caused full-year Issuer revenues to jump 34% to £27m. The number of flotations in the year fell from 289 to 202, though the Exchange did account for 69% of all Western European IPOs.

Cash flow

Year to 31st March          1999     2000     2001     2002     2003

Operating Profit (£m)       27.7     47.0     58.7     70.5     81.7

Working capital change (£m) (3.3)   (16.1)    (4.5)    (4.0)   (20.8)

Depreciation (£m)           33.1     22.2     19.9     17.5     19.0
Capital Expenditure (£m)   (25.6)   (14.7)   (22.7)   (15.8)   (28.1)

Working capital took a knock in the second half, with a large increase in debtors causing a £21m full-year outflow. No explanation was given in the results statement and this entry is something to monitor in future. While capital expenditure jumped to £28m in fiscal 2003, the past five years has seen the depreciation charge match the cash spent on tangible fixed assets. During the year, the LSE stashed another £21m in the bank to take the company cash pile to £211m (or 71p per share)

Calculating the LSE's incremental return on equity performance is a complex and largely academic task. Over the last few years, the LSE has transformed from a quasi-mutual to a public company, 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 2003 earnings of £61m and a year-end equity base of £322m, the LSE's return on equity comes to a sound 18.9%. That calculation, plus the fact the LSE has a substantial (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, suggests the LSE can reinvest its future profits at superior rates of return.

One interesting balance sheet footnote concerns the LSE company pension, which, on a FRS17 basis, has a £28m shortfall. Notably, the scheme now consists of 23% equities and the trustees plan to gradually move to 100% bonds over the long term. Hardly the greatest advertisement for share ownership!

Valuation and summary

The year to March 2003 saw the LSE generate 19.5p of free cash. Adjust for the cash pile and, at 324p, the shares offer a historic free cash flow yield of 7.8% -- an attractive rating. 

Although the LSE has reported a robust set of figures, investors shouldn't extrapolate today's double-digit growth far into the future. Listing fee increases can only go so far, while terminal data income remains under pressure and IPO markets continue to be weak.

In the short-term at least, the main revenue driver will be the increasing usage of SETS, which presently accounts for 50% of all trades. New business initiatives, such as a market data warehouse, a derivatives trading platform and the introduction of covered warrants, could provide additional revenues in the next few years. But significant profit growth will only occur when the next bull market arrives.

Nevertheless, long-term shareholders can heart from the following UK equity statistics, which are all key revenue drivers for the LSE:

Year     Turnover    Bargains    Market Capitalisation   Money Raised
           (£m)                         (£m)                  (£m)

1965      3,478.6    3,417,395         32,204.0                -
1972     20,065.7    6,724,998         60,074.4                -
1982     35,025.2    3,497,730        122,278.6             2,918.9 
1992    433,858.9    8,507,598        624,393.3            10,877.6
2002  1,815,034.2   37,508,832      1,147,827.3            25,462.3



Annual growth to 2002

From     Turnover    Bargains    Market Capitalisation   Money Raised
            (%)        (%)             (%)                    (%)

1965       18.4        6.7            10.1                    -
1972       16.2        5.9            10.3                    -
1982       21.8       12.6            11.9                   8.9
1992       15.4       16.0             6.3                  11.4

The conclusion is simple: over time, total share turnover, trading volumes, the size of the market and the money raised from flotations and rights issues... go up.

More: London Stock Exchange website | discussion board

The author owns shares in the London Stock Exchange.