Stock exchanges face some challenges

But, as in all times of flux, challenges create opportunities. For one, investor sentiment can change quickly – and that leads some analysts to favour shares in Germany-based Deutsche Boerse AG. The theory is that Deutsche Boerse stock’s very low price is based on expectations of Europe remaining mired in recession. So, if economic growth surprises on the upside, the surge of interest in European stocks will push up Deutsche Boerse’s volumes, thus increasing its earnings.

There isn’t a similar potential driver for Toronto-based TMX Group Ltd., but a report from John Reucassel, managing director with BMO Capital Markets Corp., has an “outperform” rating on TMX’s stock. Although Reucassel admits in the report that TMX’s revenue outlook has weakened, he nonetheless is impressed by the way the firm is keeping costs in line. The report also points out that the synergies from the Maple Group Acquisition Corp. takeover last year are expected to begin in 2014, which “should provide attractive leverage to improving market conditions.” The report also notes several other growth opportunities.

One thing worth keeping in mind is that the stock exchange sector is one in which mergers and acquisitions are particularly likely. It was a takeover bid launched by London Stock Exchange Group PLC (LSE) that spurred the Maple Group offer for and subsequent purchase of TMX. Atlanta-based Intercontinental Exchange Inc. got approval for its takeover of New York-based NYSE Euronext Inc. in June, which, in turn, followed NYSE Group Inc.’s acquisition of Euronext NV in 2007, and Deutsche Boerse’s unsuccessful bid for that entity in 2011.

Here’s a look at Deutsche Boerse and TMX in more detail:

– DEUTSCHE Boerse AG gets about 40% of its revenue from the Eurex Exchange, the largest global derivatives exchange, and 10% from the Xetra electronic trading system, the second-largest cash equities market in Europe. Another 30% of Deutsche Boerse’s revenue comes from Clearstream Banking SA, one of Europe’s major central securities depositories, which provides clearing and settlement services.

Deutsche Boerse has a very strong balance sheet and very stable earnings, says Mark Grammer, senior vice president, investment management, with Toronto-based Mackenzie Financial Corp. He notes that the bourse has “quietly performed well” in the past few years despite lower trading volumes: “It’s done a good job of managing its exchanges and controlling costs.”

Grammer considers Deutsche Boerse’s stock price to be depressed and expects it to rise as a result of the annual double-digit growth in earnings per share (EPS) he anticipates over the next three years. He thinks Europe’s growth could surprise on the upside, which would lift Deutsche Boerse’s trading volumes. In addition, the bourse will benefit when interest rates start to rise – every increase of 100 basis points adds 5%-10% to EPS.

Although Grammer agrees that the EU’s proposed FTT is a risk, he thinks the impact is likely to be less than expected; when investors realize this, that will lift Deutsche Boerse’s stock price.

The FTT, aimed at discouraging speculative trading and getting back some of the money given to EU banks following the global financial crisis, was originally proposed as a 0.1% levy on stock and bond trades and a 0.01% levy on derivatives transactions (if at least one of the parties was located in the EU) as of Jan. 1, 2014. In June, implementation of these levies were delayed by six months; now, EU diplomats say the tax could be scaled back significantly.

Although Charles Burbeck, co-head of global equity portfolios with UBS Global Asset Management (U.K.) Ltd. in London, doesn’t hold Deutsche Boerse’s stock in any of the mutual funds he manages, he agrees the bourse could be a good play on a recovery in European equities. Burbeck also says these shares could be a good longer-term investment because European companies are expected to increase their use of capital markets to raise funds rather than rely primarily on bank loans.

A recent report from UBS analysts in London rates Deutsche Boerse’s stock a “buy,” citing its “robust balance sheet,” fairly stable earnings, stable 4.5% dividend and “exposure to a cyclical recovery in volumes.” The report’s 12-month price target for the stock is 60 euros, or around US$8 for the American depositary receipts (ADRs), which closed at US$7.38 on Aug. 9 on the New York Stock Exchange. There are 186 million outstanding shares.

In the longer term, UBS analysts expect 10% compound annual EPS growth in the next five years as the firm takes advantage of structural changes, such as product innovation, increased collateral requirements and over-the-counter clearing, which will be allowed in the EU on Jan. 1, 2014.

Analysts with J.P. Morgan Securities LLC in London still prefer Deutsche Boerse to other publicly traded stock exchanges but they downgraded their “buy” rating to “neutral” in a report released in early June – and their price target of 50 euros is much lower than UBS’s 60 euros. This downgrade is based on disappointing results, which have resulted in a downward trend in consensus EPS expectations over the past few years.

Deutsche Boerse’s net income was 299.7 million euros for the six months ended June 30 vs 340.5 million euros in the corresponding period the year prior. Revenue was unchanged, at 1.1 billion euros.

– tmx group ltd. Maple Group’s acquisition of TMX in 2012 had formidable backing, including four of the Big Six banks – Canadian Imperial Bank of Commerce, National Bank of Canada, Bank of Nova Scotia and Toronto-Dominion Bank – major pension funds Desjardins Financial Corp., Dundee Capital Markets Inc., and Manufacturers Life Insurance Co.

However, TMX faces new competition in Aequitas Innovations Inc., which plans to establish a new stock exchange backed by Royal Bank of Canada (RBC), Barclays PLC, CI Financial Corp. and IGM Financial Inc.

TMX operates the Toronto Stock Exchange, the TSX Venture Exchange and the Montreal Exchange. TMX also has a 53.8% interest in BOX Market LLC, a U.S. equities options market, operates two alternative cash equities exchanges (TMX Select and Alpha), and offers trading in natural gas and oil. TMX also offers depositary, information and technology services.

Most analysts are unenthusiastic about TMX’s prospects in the near term, but a report from Reucassel has an “outperform” rating on the stock with a price target of $58, well above the $48.02 that the 54.1 million outstanding shares closed at on Aug. 9. Reucassel’s report notes that $58 represents an 11% discount to the current price for the Australian Stock Exchange, which Reucassel considers to be most comparable to TMX.

In particular, Reucassel is impressed with the way TMX has kept its costs in line during the past few years of low trading volumes. He expects this to continue in 2013 but believes markets will be more “normalized” in 2014, when synergies from the Maple Group transaction will kick in.

He also believes recent transactions – the fixed-income joint venture with FTSE Group (part of LSE) and the acquisition of a transfer agent and corporate trust business – will lead to “interesting growth opportunities” that will allow TMX to diversify its transactions-based revenue into higher-margin lines of business.

In contrast, analysts with RBC’s capital markets division and with TD Securities Inc. aren’t enthusiastic. Both firms have price targets of $45-$46 for TMX. An RBC report expects the stock to “underperform” and notes increased derivatives trading competition in the U.S. And a TD report suggests that investors “reduce” their holdings, noting the risks of greater regulatory oversight, downward pressure on market data fees and competition from Aequitas.

TMX’s net income was $63.2 million for the six months ended June 30 on revenue of $354.5 million. Comparable figures from a year earlier are not available, as the Maple Group acquisition wasn’t completed until August 2012.

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