QUALIPORT
Qualiport Resists The Germans

By Maynard Paton (TMFMayn)
December 14, 2004

The Qualiport's biggest holding, the London Stock Exchange (LSE: LSE), yesterday confirmed it had received a bid proposal. The possible offer from Deutsche Boerse was for 530p per share in cash and represents a significant profit on the portfolio's 336p average purchase price.

So what now?

Points to consider

There are three main points to consider with the LSE and the bid:

1. Super company: The LSE is arguably Britain's best business. As well as being highly visible to ordinary investors and benefiting from repeat demand for its products and services, it enjoys substantial barriers to entry, low industry competition, few substitutes and obvious growth potential.

After joining its own market in 2001, the LSE has remained a steady performer. We are not talking of past Qualiport disasters MMT Computing or PizzaExpress here, where the loss of their 'possible' bids meant being left to stick it out with an underachiever.

2. Valuation: The indicated 530p offer puts the LSE on a forward price to earnings (P/E) ratio of 23 and a dividend yield of 1.1%. Adjusting for net cash of around £141m or 55p per share (which accounts for acquisition earn-out payments and property disposal proceeds), the historic free cash flow yield comes to 4.8%.

Deutsche Boerse it seems won't get away with buying the LSE on the cheap. But if a deal goes ahead, the Frankfurt exchange will benefit from subsequent cost cutting. A large element of costs encountered by the two stock exchanges are essentially fixed (e.g. a doubling of transactions going through the LSE's SETS order system would not equate to a doubling of operating expenditure) and are very similar in nature, giving Deutsche Boerse scope to justify a buy price higher than the (sensible) ordinary punter.

For its part, the LSE "firmly believes that the proposal undervalues the [LSE] and the substantial synergies that would be available from the combination of LSE with another major exchange group."

3. Chance of a higher bid: Both parties are still talking.

The LSE "has agreed to hold discussions with Deutsche Boerse to ascertain whether a significantly improved proposal that would be in the interests of LSE's shareholders and customers and that would be capable of being implemented can be agreed."

Deutsche Boerse declared: "Although the London Stock Exchange has rejected the proposal they have invited Deutsche Boerse to hold discussions regarding the possibility of an agreed transaction. Deutsche Boerse has accepted the invitation in order to demonstrate to the London Stock Exchange the full benefits of its proposal and its belief that such a proposal can be successfully implemented."

So it seems the LSE is reasonably open to offers, unlike, say, the board of Marks & Spencer (LSE: MKS) was with Philip Green. It's also worth remembering the LSE and Deutsche Boerse agreed to form iX in 2000, but the deal unravelled following various regulatory and user issues. If nothing else, Deutsche Boerse appears persistent with its courting.

Another wild card is Euronext (the operator of the Paris, Brussels, Amsterdam and Lisbon stock exchanges) stepping in with a bid. Indeed, don't forget the battle for LIFFE in late 2001, in which the LSE, Deutsche Boerse and Euronext all bid up the London futures exchange to £555m and a P/E of around 40. Dominant trading exchanges are not put 'in play' that often and, when the opportunities arise, industry players can find paying up very tempting.

What now?

It's very tempting for the Qualiport to sell all or part of its LSE holding. Deutsche Boerse may withdraw its interest, the 530p offer price seems reasonable (though not overly generous) and there are various regulatory and competition issues that may scupper a deal whatever the terms.

A disposal now would also lock in a 60%-ish gain on the Qualiport's LSE investment and help cement a 28% profit for the portfolio in 2004. It would also free up some cash ready for when other watch list shares fall into attractive buying territory.

However, companies of the LSE's quality are few and far between and the Qualiport's long-term success has not been based on making decisions with one eye on short-term performance figures. In addition, the two exchanges remain in talks and a higher bid could be just around the corner.

More importantly perhaps is that an independent LSE could be valued at much greater than 530p a share in the years to come.

Despite lacklustre predictions for the current financial year, history has shown the key drivers of the LSE's income -- total equity turnover, trading volumes, demand for market data, the value of listed companies and the money raised from flotations and rights issues -- go up over time. Indeed, these profit drivers are inherently limitless.

When the next bull market gets into full swing, the operational gearing of the LSE will almost certainly mean profits coming in a lot higher than the levels seen today. And during buoyant market conditions, it's a fair bet the LSE's competitive strengths and earnings growth will (at times) prompt investors to at least match the P/E of 23 currently offered by Deutsche Boerse.

In summary, the Qualiport is all about buying great companies at attractive prices and holding for the long run. The LSE is a superb business and -- bar raising cash to purchase a new portfolio member -- the Qualiport will for now resist the German advance and hang on to its LSE shares in the belief they'll be worth more sometime in the future.

More: Britain's Best Business | Special Company, Special Dividend

Maynard owns shares in the London Stock Exchange.

Portfolio value

Holding	Number of shares	Closing price 13/12/04 (p)	Value (£)
Associated British Ports	681	478.5	3,258.59
Emap	372	818	3,042.96
Halma	1,920	156.75	3,009.60
Johnston Press	1,608	526.5	8,466.12
London Stock Exchange	2,018	540	10,897.20
Cash			87.41
Total			28,761.88