Canada’s resources boom is making Canadian stocks hot commodities, bringing foreign investors to Canada and keeping domestic assets at home. As long as that continues, prospects are rosy for TSX Group Inc.

But the Toronto-based company — which encompasses the Toronto Stock Exchange, the TSX Venture Exchange and NGX, a North American natural gas and electricity exchange, as well as trading and data distributors TSX Markets and TSX Datalinx — isn’t without challenges. Competition from U.S. exchanges for listings and trading volume — the group’s main source of revenue — is fierce. And the growing presence of automated trading systems could change the competitive landscape.

TSX Group CEO Richard Nesbitt, however, is pleased with progress. “Things have never been better,” he says. And there is more to come. “We are in a reasonably early stage of the commodity and energy cycle.”

Certainly, most analysts agree that oil and metals prices are likely to stay high for quite a few years to come, which is nothing but good news for TSX Group. It has already ridden the resources boom — as well as the explosion of income trust listings — since it went from being a member-owned exchange to a publicly listed company in November 2002.

Its flagship TSX is a key market globally for resources stocks. Its array of listings account for 60% of world market capitalization of gold stocks and 50% of all global mining stocks. In energy, it’s aspiring to reach 50% of the world’s total market cap, even though it’s missing some big international players — ExxonMobil Corp., BP PLC and the Royal Dutch/Shell Group.

But even with these notable absences, the TSX is a major exchange and is particularly strong in the universe of small and medium-sized oil and gas companies. TSX Group’s acquisition of NGX has only added to its arsenal; it is now involved in discussions concerning the development of a global carbon trading system.

The sustainability of the income trust boom is a little more suspect, however. Canada’s new Conservative-led minority government is expected to go ahead with the Liberals’ pre-election compromise to increase the Canadian dividend tax credit, which will lower but not eliminate the incentive for companies to convert to trusts.

As well, there is a significant number of weak trusts, which have or may have to cut distributions. Some analysts believe the income trust boom is a speculative bubble — one that could easily burst.

But the possible fall of the income trust market is far from the only risk facing TSX Group. Rather, the biggest threats on the horizon are ATSes and U.S. exchanges that are attempting to woo Canadian companies to interlist or, in the case of smaller-cap companies, to choose Nasdaq over the TSXV.

Nesbitt says TSX is winning the battle for listings. In 2005, listings in Canada rose to 1,537 from 1,340 two years earlier, while U.S. listings remained basically flat. Resources accounted for a third of the 555 new listings in the past three years; income trusts, which were mostly business trusts, accounted for 18%. Structured products were responsible for 28%, and the rest were mainly in the financial services, technology and biotech sectors.

Nesbitt is particularly pleased with the technology and biotech additions. He mentions Montreal-based Miranda Technologies Inc., which went public in December, as the biggest of a number of technology firms that are choosing to list on TSX Group’s exchanges rather than competing exchanges such as Nasdaq. In biotech, TSX Group is the second-largest exchange globally in terms of the number of listed companies.

“Canadian companies are serviced much better by a domestic stock exchange,” says Nesbitt. “We’re very friendly to small and medium-sized companies. We work together.” A case in point: TSX Group created CNX Marketlink with CNW Group Ltd. in 2003 to provide publicly traded companies with enhanced investor communication tools.

As for ATSes, Nesbitt downplays the threat they present; he looks at ATSes as customers because they buy data and distribute their trades through the TSX. But despite Nesbitt’s positive spin, ATSes could dampen TSX Group’s trading revenue. If over time, more trades are done on ATSes than on TSX Group exchanges, the latter company will lose revenue or, at least, see less growth. Given trading’s financial heft — it and related activities accounted for 43%, or $92.5 million, of total revenue of $213.7 million in the nine months ended Sept. 30 — that could have an impact. By contrast, listings accounted for $64.6 million of nine-month revenue and market data sales for $49.6 million.

@page_break@TSX Group does say it is monitoring ATSes and will respond to their challenges if deemed necessary; however, it doesn’t say what actions it would take.

Financially, TSX Group has fared well. Net income for the nine months was $75.5 million, up from $49.9 million in the same period a a year earlier, when revenue was $179.6 million. (Fourth quarter results were to be released Feb. 1, after Investment Executive went to the printer.)

The 2004 figures were restated to reflect a change in accounting rules concerning the recognition of non-refundable fee revenue, which is now amortized rather than recorded when received. This lowered both revenue and net income. In 2005, cash flow after net change in non-cash working balances was $114.7 million for the nine months, vs $97 million for the same period a year earlier.

TSX Group has 68.1 million outstanding shares. In mid-January, a share was trading at $47, up from the initial offering price of $10 and adjusted for a two-for-one stock split in May 2005. Quarterly dividends have increased each year to 25¢ as of Aug. 31. There was also a special dividend of $5 a share, pre-split, on Dec. 31, 2003. The company has a policy of reinvesting cash or returning it to shareholders.

TSX Group’s strategy is to build on its strengths at home while expanding outside Canada. It wants to continue to attract new listings and encourage foreigners to trade shares of Canadian companies. It also wants to foster the development of new products.

The first priority is maintaining first-class trade execution technology. The sector is “very, very competitive,” says Nesbitt. “We cut trading fees every year, as do the New York Stock Exchange and Nasdaq. We kicked off the process; they accelerated it.”

TSX Group has made three major investments in technology in the past 18 months, increasing both trading capacity and speed.

There has also been a strong focus on productivity. Since 1999, when the TSX merged with the Alberta and Vancouver stock exchanges and formed the TSXV, staffing has fallen to 510 from 740. Among the current employees are 30 who work on the NGX, an electronic exchange that trades and clears natural gas and electricity contracts. TSX Group acquired NGX in March 2004 from OHMEX AB, the Sweden-based owner and operator of securities exchanges in Copenhagen, Stockholm, Helsinki, Riga (Latvia), Tallinn (Estonia) and Vilnius (Lithuania).

Marketing offshore

TSX Group’s second priority is widespread marketing. Now is an ideal time: with the TSX outperforming U.S. indices in each of the past five years, U.S. interest in Canadian stocks is high. “People have figured this out. There’s an upsurge in activity,” says Nesbitt.

Of course, much of this is due to booming resources. But, given sales to China and interest in and development of the tarsands in northern Alberta, he says, “It seems like strong commodities are here to stay.”

The company’s marketing initiatives include partnering with investment dealers to raise the profile of Canadian capital markets both at home and abroad; supporting innovative products such as investment funds and exchange-traded funds; and working through its U.S.-based sales team to deepen relationships with vendors and to increase data sales. It also plans to showcase the speed and efficiency — and the lack of interference from specialists — of buying Canadian stocks through Canadian exchanges, says Nesbitt.

TSX Group is also betting on an increase in electronic bond trading through its 45% ownership of CanDeal.ca Inc., which was launched in 2002. (Its co-owners are the Big Six chartered banks.)

TSX Group is optimistic about the prospects for CanDeal. Debt markets are strong, says Nesbitt, and capital is “flooding into Canada to finance energy and other industries.” Currently, CanDeal trades only Government of Canada and provincial bonds, although it plans to add money market instruments and corporate bonds. The challenge is to build scale — CanDeal accounts for only about 5% of total Canadian bond trading. There are eight brokers making prices and 65 institutions on the buy side.

CanDeal is not without challengers. One is Toronto-based Perimeter Financial Corp. (see page 34), which has an ATS, CollectiveBid Systems Inc. , that provides data on pricing of government and corporate bonds and operates two bond marketplaces, one for institutions and one for retail investors.

Another Perimeter ATS, BlockBook, is going after the institutional market with the promise of automated anonymous equity trading.

Nesbitt doesn’t think these ATSes present a serious competitive threat to TSX Group’s business of selling stock data and distributing stock trades, pointing out that competitors have tried and weren’t successful. “The TSX is the centre point of price discovery,” he says. But it’s as much a question of liquidity as price discovery. Wide distribution of prices encourages trading and liquidity.

As for TSX Group’s NGX business, Nesbitt says, it’s been very successful, with volumes up 30%. As a result, TSX Group is planning on expanding NGX by designing physical commodity contracts for key regional markets in the western U.S. that leverage NGX’s existing systems and customer base.

For the time being, TSX Group isn’t interested in carbon trading; there are already three North American exchanges offering it. However, it is working with large carbon emitters and governments to find a trading solution that integrates with those in Europe and the U.S.

TSX Group is also interested in developing more innovative products. It successfully launched Market on Close for firms requiring a closing price on a trade; Icebergs for disproportionally large orders (with only a portion of the trade made public); and voluntary attribution on orders — the last two of which were launched on the TSXV in the past few months. If product developments aren’t successful, as was the case with stock symbol extensions and POSIT Canada, they are discontinued.

Other possibilities include over-the-counter instruments, such as credit, foreign exchange and crude oil derivatives. TSX Group has a “non-compete” agreement with the Montreal Exchange keeping it out of domestic options and futures until 2009, but it can participate in those markets outside Canada.

TSX Group’s continued success depends on co-operation from other parts of the financial markets, including regulators. With 13 jurisdictions, Nesbitt says, Canadians “don’t regulate effectively.” Thus, TSX Group fully supports a national regulator that’s “in tune with the unique nature of Canadian companies, including small- and medium-cap, and the regional requirements of industries, such as energy in Alberta and biotech in Quebec and British Columbia,” he says.

However, the increased regulation of recent years hasn’t affected listings, says Nesbitt. Regulation has been adapted for Canada. For example, the TSX and TSXV have harmonized rules to make graduation to the TSX easier. IE