QUALIPORT
The LSE Is Worth 600p Per Share

By Maynard Paton (TMFMayn)
March 15, 2005

It's been three months since the London Stock Exchange (LSE: LSE), the Qualiport's largest holding, received a bid proposal from German rival Deutsche Boerse.

In that time, LSE shareholders have heard from the stockbrokers, the bankers, the politicians, the FSA and the newspaper pundits, who've pontificated about trading charges, the City's reputation, corporate governance, management structures, settlement facilities, so-called vertical silos and regulation should the LSE change hands.

Sadly, LSE investors have heard precious little about the financial merits of any deal. Most of the 'value' talk has come from a band of rebel Deutsche Boerse investors, which scuppered the Frankfurt exchange's bid last week.

The rebels cited an excessive premium and 'considerable risks' to the acquisition, and prefer Deutsche Boerse to buy back its own shares. For its part, the LSE had already rejected Deutsche Boerse's approach, stating the proposal recognised 'neither the Exchange's inherent value and growth prospects, nor the substantial synergies available in a combination'.

Let's have a closer look at the financial terms of the Deutsche Boerse proposal.

Deutsche deal

Deutsche Boerse published a proposed pre-conditional cash offer on 27 January. The details included:

* a 'price of not less than 530p per share'.
* an 'additional contribution to profit before tax from revenue and cost synergies of at least €100m per annum'.
* 'total restructuring costs to be less than €100m'.

Here are some rough calculations:

* The LSE's latest results showed twelve-month 'operational earnings' (essentially free cash flow) of about £58m (or 22.6p per share), and net cash of £141m.
* With 255m shares in issue, Deutsche Boerse's 530p per share bid valued the LSE at £1.35b.
* But add integration costs of €100m (£70m) and subtract the LSE's cash pile (£141m), Deutsche Boerse would have effectively paid £1.28b.
* Then add cost savings of €100m (£70m) taxed at 30% (giving €70m or £49m) to the LSE's current operational earnings, and the LSE's post-merger earnings would come to £107m.
* The effective price to earnings (P/E) ratio would have been £1.28b / £107m = 12.0.

A P/E of 12 looks good value to me. So why did rebel Deutsche Boerse shareholders scupper the German exchange's deal? Perhaps the German exchange couldn't really afford to finance a deal?

In 2003, Deutsche Boerse reported pre-goodwill operating profits of €528m, or £369m. The LSE could in theory contribute an extra £107m, taking total operating profits to £476m.

Assuming an additional £1.4b of debt is used to fund the purchase at, say, 7% interest, and (with minimal other borrowings) Deutsche Boerse's annual interest bill would come to £98m. Interest payments would be covered around five times (£476m / £98m) at a Deutsche Boerse/LSE combination -- about the minimum shareholders ought to demand, even for near monopoly businesses.

Given these calculations, I can understand why Deutsche Boerse boss Werner Seifert was so insistent on pushing the deal through and ignoring the dissident investors. Financially at least, the sums seemed to stack up for his shareholders.

Euronext elements

The LSE is currently in takeover talks with Euronext, owner of the French, Belgian, Dutch and Portuguese bourses. Euronext announced its key elements of a potential cash offer on 9 February. The details included:

* 'annual pre-tax cost and revenue synergies of €203m'.
* 'total restructuring and revenue investment costs estimated at €184m'.

Things are complicated slightly as Euronext did not reveal an indicative bid price. However, the LSE has (reportedly) just set a minimum of 590p to 600p per share for any takeover, so let's go with 600p. Here are some more calculations:

* The LSE's latest results showed twelve-month 'operational earnings' (essentially free cash flow) of about £58m (22.6p per share), and net cash of £141m.
* With 255m shares in issue, a 600p per share bid would value the LSE at £1.53b.
* But add integration costs of €184m (£129m) and subtract the LSE's cash pile (£141m), Euronext would effectively pay £1.52b.
* Then add cost savings of €203m (£142m) taxed at 30% (giving €142m or £99m) to the LSE's current operational earnings, and the LSE's post-merger earnings would come to £157m.
* The effective P/E ratio is £1.52b / £157m = 9.7.

On the face of it, Euronext could buy the LSE on a P/E of below 10 -- a great deal. But can the Paris-Brussels-Amsterdam-Lisbon exchange afford it?

In 2004, Euronext produced pre-goodwill operating profits of €240m, or £168m. The LSE could bring it an extra £157m, taking total operating profits to £325m.

Assuming an extra £1.5b of debt is used to fund the purchase at, again, 7% interest, and (alongside £100m of existing net cash) Euronext's annual interest bill could come to approximately £100m. Interest payments would be covered around three times (£325m / £100m) within a Euronext/LSE combination -- far too low I think for Euronext investors to contemplate.

Summary

These are crude calculations. The cost savings and revenue benefits will in reality flow through over a few years and there's a risk the projections may be too optimistic. (In contrast, you can be sure all the proposed restructure expenditure will be spent quite quickly.)

Nevertheless, it's pretty clear to me that the LSE was right to dismiss Deutsche Boerse's proposal as undervaluing its business. And the LSE is right to (reportedly) demand at least 590p-600p from Euronext. The purchase P/Es I've calculated look pretty undemanding from a bidder's point of view. It would be interesting to see some alternative figures from the protesting Deutsche Boerse investors.

What seems to be the main stumbling block for the two European bidders is their ability to service the additional debts that are required to fund a bid. To succeed, they may have to concoct a rights issue or some sort of (very) favourable share-based merger deal. But the financial limitations of the predators shouldn't prompt LSE investors to sell out on the cheap.

Suffice to say, the LSE is a wonderful business franchise and offers plenty of financial opportunities for any rival exchange group prepared to buy it. In my book, they'll need to pay over 600p a share.

Maynard owns shares in the London Stock Exchange.

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