What's the Trade for This Trader?

Marshall is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investors in NASDAQ OMX Group (NASDAQ: NDAQ) took a big hit this week, with the stock sinking almost 14% on the news that the trading platform company will purchase eSpeed. The company plans to shell out $750 million in cash plus another $450 million in contingent stock issuances to buy the U.S. Treasury electronic-based trading unit, eSpeed, from BGC Partners. 

However, are the long-term benefits outweighing the short-term pressures, providing investors a chance to scoop up this trading company for cheap? 

Nasdaq was poised to make a growth spurring move, as trading volumes and consolidation have been spreading across the industry. The deal will allow Nasdaq to take control of the electronic platform for banks and firms trading "on-the-run" Treasury securities. The real fear for investors is the fact that the deal could put further pressure on Nasdaq's balance sheet. The company already has a 38% debt to equity ratio, but this really isn't any worse than major competitors.  

Tailwinds From eSpeed

Nasdaq is known for its presence as a stock market, but its newest addition is one of the largest venues for banks and firms trading "on-the-run" Treasury securities. The platform generated revenue of almost $100 million in 2012, leaving room for substantial growth. The deal is also expected to be accretive to earnings within the first twelve months after closing.

Nasdaq CEO Robert Greifeld notes that "eSpeed is poised to benefit from trends like stability in the issuance of new Treasurys and the electronification of the Treasury market."

The deal should give Nasdaq a better blend of products by moving into the principal-based fixed income trading market. Nasdaq plans to target a 75% mix of recurring revenues over the near term, with big help from its other recent acquisition of the investor relations unit from Thomson Reuters. 

What's more is the company has a somewhat more diverse revenue stream than major peers, getting just over 65% of revenues from transactions and broker services. Its issuer services account for over 20% of revenues and includes capital raising solutions, and its market technology segment is close to 15% of sales, which includes market data and index services. Although hedge fund sentiment turned negative during the fourth quarter, one hedge fund remains a big believer; JHL Capital holds over $70 million in stock, which is 10.3% of the hedge fund's 13F portfolio value (see which funds dumped NASDAQ). 

Major Competition

Chief competitor NYSE Euronext (NYSE: NYX) has operations heavily weighted toward trading, including over 30% related to derivatives, 50% cash equities and only 20% exposed to information solutions. NYSE has been ineffective in locking down a strategic acquisition, recently ending the bid to acquire London Metals Exchange, and previously seeing the long-time merger with Deutsche Boerse fall apart in early 2012. Billionaire Leon Cooperman is one of the hedge fund managers loving NYSE, but he may well be playing the merger-arb opportunity (check out Cooperman's big shakeups).

In late 2012, IntercontinentalExchange (NYSE: ICE) announced plans to snap up NYSE in a close to $10 billion acquisition. ICE is an operator of global futures exchanges, over-the-counter (OTC) and derivatives clearing houses. What's relatively unappealing about ICE is its overexposure to transaction and clearing fees, nearly 90% of revenues; its market data segment is only 10% of revenues and offers various market data services, including publication of daily indices and validation of participants' own mark valuations.

When thinking about the NYSE-ICE merger, it's worth noting that NYSE previously shut down its trading exchange in London because it performed so poorly, suggesting any plans for expansion across the pond could see similar headwinds. 

ICE also appears to have a number of interested hedge funds buying up the stock. Senator Investment Group has the largest position in the company with a $220 million position; that puts the stock as the hedge fund's number one holding and makes up 4.8% of its 13F portfolio (see how other hedge funds are trading ICE).

The Alternatives 

CME Group (NASDAQ: CME) is a result of the 2007 merger of the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT). The company is now the the largest futures exchange in the world in terms of both trading volume and notional value. The downside to investing in CME is its exposure to extreme interest rate volatility. This has caused significant pressure on the company related to the Fed's zero interest rate policy, causing low demand for low priced products, which have caused trading volumes to be down 13% in 2012 as long-term investors remain on the sidelines. 

This is a problem, considering the company is also heavily reliant on trading volume, including reliance on two key products in its clearing and transaction segment:  interest rate swaps account for 40% of total transaction volume and equities 25%. 

CBOE Holdings (NASDAQ: CBOE) is the holding company for Chicago Board Options Exchange and focuses on options contracts. The company has been seeing volume pressures, with average daily volume 4% lower in the fourth quarter year over year and down 5% sequentially. Unlike CME, CBOE has been looking to hedge volume decline with innovation. CBOE opened a London trading hub earlier this year for 24-hour by 5-day trading. Albeit one of the better futures traders, CBOE has little hedge fund interest (see which hedge funds do love CBOE).

Other innovation and initiatives from CBOE include its proprietary products, such as S&P 500 options and options on the CBOE Volatility Index. CBOE also managed to extend its long-term contract through 2032 for exclusive rights to use the S&P 500 and S&P 100 indexes to create exchange-traded options on those indexes. 

Don't Be Fooled 

As far as valuation goes, Nasdaq appears to be much cheaper than its peers, on both a price to earnings and a price to sales basis. 

 

Nasdaq

NYSE

CBOE

ICE

CME

Price to earnings

14

28

21

22

22

Price to sales

1.5

2.5

6.3

8.6

6.8

Even if Nasdaq managed to trade on the low end of its peers at 20 times earnings, the suggested value would still be 40% upside from its current trading levels. I take the acquisition of eSpeed as a positive for the company, especially amidst an industry that is seeing various headwinds due to changing preferences. Although its balance sheet seems strained, in reality it's no worse than its major peers; NYSE has a debt to equity ratio of 40%, with ICE at 31% and Nasdaq's at 38%. 


Marshall Hargrave has no position in any stocks mentioned. The Motley Fool recommends NYSE Euronext. The Motley Fool owns shares of CME Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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