QUALIPORT
Britain's Best Business

By Maynard Paton (TMFMayn)
November 16, 2004

The London Stock Exchange (LSE: LSE) is a wonderful business franchise. As well as being highly visible to ordinary investors and benefiting from repeat demand for its products and services, the Qualiport company also scores very highly on Michael Porter's five industry forces (outlined in his celebrated book Competitive Strategy).

This article outlines the operational strengths of the LSE. For Buffett-type investors, there are few -- if any -- British companies that can beat it.

Income

To recap, the LSE has three main sources of income:

1. 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.

2. 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)).

3. Broker services:  Predominantly the charges levied against every trade made through the LSE's SETS electronic order book or reported to the LSE for subsequent publication to the market.

This is how the LSE scores on Porter's five forces:

Barriers to entry

The LSE enjoys substantial barriers to entry.

Regulation is the first hurdle for any newcomer. To become a 'Recognised Investment Exchange', various operational conditions of the Financial Services and Markets Act 2000 have to be met, not least those concerning investor protection, ensuring orderly trading and maintaining generally high standards of business integrity.

There are IT costs as well. Developing the equivalent of SETS does not come cheap. In the LSE's 2003/4 annual report, capitalised software had a net book value of £35m.

But liquidity is the main barrier. Stock exchanges need plenty of buyers and sellers to create an efficient marketplace. As such, new entrants face the age-old problem of tempting traders and listed companies away from established exchanges. Even though transactions may be cheaper on a rival exchange, an investor won't migrate if nobody is going to be on the other end of his trades. Furthermore, a LSE-listed company is not going to pay for a second listing elsewhere just for a few extra transactions in its shares.

A quick check on the LSE's domestic competitors provides evidence of the company's dominance:

1. PLUS Markets (LSE: PMK), which operates the OFEX market, is currently valued at £1m. Following the growing success of the LSE's junior Alternative Investment Market (AIM), OFEX was forced to raise emergency funds in October. OFEX handled 8,456 trades in the first nine months of 2004 and was home to 137 listings at the end of September. The equivalent statistics for the LSE are 40m trades (1.2m on AIM) and 2,765 listings (936 on AIM).

2. Virt-x is a subsidiary of the Swiss Stock Exchange. Although in operation for eight years, the former Tradepoint system has barely dented the LSE's market share. This table compares the top five shares traded on Virt-x with the equivalent on the LSE:

October 2004	Virt-x turnover (£m)	Virt-x no. of trades	LSE turnover (£m)	LSE no. of trades
BP (LSE: BP.)	68	1,590	12,075	80,941
HSBC (LSE: HSBA)	53	1,512	6,560	69,133
Royal Bank of Scotland (LSE: RBS)	38	3,343	4,585	74,954
Unilever (LSE: ULVR)	30	531	3,024	42,404
Tesco (LSE: TSCO)	26	1,940	2,342	53,263

3. Finally there's ShareMARK, which hosts thirteen listings. Five of these are also traded on AIM, with another being that of its parent company, Share plc (worth £21m).

Intensity of rivalry

With British rivals nowhere, the LSE's main competition comes from abroad. However, investors generally have xenophobic tendencies (when it comes to shares at least!), meaning rivalry between incumbent stock exchanges is not cut-throat.

For instance, few British investors are interested in foreign companies, and those that are tend to focus on American shares (which list on the New York Stock Exchange or Nasdaq anyway). On the same note, it's fair to say the typical overseas punter is uninterested in all but the biggest of British multinationals (Vodafone (LSE: VOD) etc.). The upshot of this patriotism is that companies generally list on their domestic exchange, with perhaps a dual listing (e.g. an ADR on New York) elsewhere to keep a few overseas traders happy.

In Europe, it's fair to say the London market has greater prestige and international standing than Frankfurt and Paris. This perhaps is reflected by the fact that around 80% of flotations in Western Europe over the last year or so have occurred on the LSE's markets.

Substitutes

There is no direct alternative to buying shares. But there are a number of indirect substitutes, ranging from putting cash in a savings account to exotic derivatives. Companies can also raise funds away from the equity market (though their bonds can still be traded via the LSE). How financial markets will evolve in the future is anybody's guess, but 200 years of stock market history suggests share trading in London will remain an important part of the investment landscape for some time to come.

Power of customers

The LSE's customers possess limited pricing power. For example, the LSE hiked listing fees by 70% in April 2002 and still did not suffer a mass exodus from its markets. (It did however suffer an investigation by the OFT, which reduced the tariffs for 2004). Organisations receiving or republishing share price and index data from FTSE (a joint venture between the Financial Times and the LSE) have also suffered stiff price increases of late.

An interesting test case of customer power comes in the form of SETSmm. The LSE wants to extend the hybrid trading platform by adding all 335 Small-Cap members and 100 AIM shares to the system. (A pilot is underway to reduce SETS tick sizes, too). The introduction of SETSmm last year cut spreads by 40% on 200 shares, so obviously the latest plans have outraged some City banks and market makers. Next year will see the outcome of this particular battle, but it's difficult to see the LSE being defeated when investors can see the prospect of lower costs.

Power of suppliers

The LSE's major suppliers are its employees. But despite earning £64,000 on average in 2003/4, the operative strengths outlined above means particular individuals are not required for long-term success. Indeed, the LSE has seen numerous bosses come and go over time, but it has remained the dominant UK operator throughout. More recently, the departure of Simon Brickles, former boss of AIM, to OFEX has not sparked a mass departure from the LSE's secondary bourse.

IT, which is outsourced, could be one supplier problem. However, the LSE's systems have proved remarkably robust over time (save for one embarrassing failure in 2000), with Accenture having its contract renewed twice since 1992.

Results

Interim results published last week underline the LSE's operational 'moat':

Six months to	30 Sep 2004	30 Sep 2003
Turnover (£m)	118.3	113.4
Operating profit (£m)	40.0	42.1
Net interest receivable (£m)	4.1	3.0
Exceptional items (£m)	5.0	-
Pre-tax profit (£m)	49.2	45.1
Earnings per share (p)*	10.7	10.7
Dividend per share (p)	2.0	1.4

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

Turnover edged 4% higher, as greater Broker and Information sales offset lower listing fee income. The sale of the old Stock Exchange tower and a move into new leasehold premises prompted the exceptional gain and dip in operating profits. Nevertheless, margins at 34% remain very attractive. On the balance sheet, net cash of £114m was declared, although £6m is set to pay off a past acquisition while property sale proceeds of £33m are due at the end of 2005.

With:

* operating profits of £82.2m recorded in the year to September 2004;
* maintenance capital expenditure assumed to equal depreciation;
* corporation tax at 30%;
* net cash of £141m (about 55p per share) and;
* 254m shares in issue

… the shares at 393p offer a historic free cash flow yield of 6.7%. A 357p buy price is therefore needed to earn 7.5%.

The only worry at the moment is the amount spent on the new offices. Net capital expenditure came to £26m between March and September. As well as The Source (an 8-storey high, 729-sphere 'dynamic piece of sculpture'), the LSE's new place also includes two glass atria, walnut veneer doors and woven steel for wallpaper. The benefit to shareholders of this lavish interior design is not clear -- but then again, there is no such thing as the perfect company!

Maynard owns shares in the London Stock Exchange.

Portfolio value

Holding	Number of shares	Closing price 15/11/04 (p)	Value (£)
Associated British Ports	681	469.5	3,197.30
Emap	372	811.5	3,018.78
Halma	1,920	159	3,052.80
Johnston Press	1,608	540	8,683.20
London Stock Exchange	2,018	396	7,991.28
Cash			87.41
Total			26,030.77