How far will the knife fall?
Exchanges and telecommunications technologies are two of the key themes I explore at the Park Paradigm. Long-time readers will know that I think there are many strategic parallels between the two industries:
- platform companies with large fixed capex and opex requirements but low marginal unit costs
- traditional business model predicated on (high) fixed transaction fees
- traditionally protected and highly regulated local monopolies
- very strong demand elasticity – decreases in price (initially) offset by even larger resulting increases in volumes
- traditional business model vulnerable to catastrophic failure via a toxic combination of deregulation/opening of market to competition, and advances in technology driving transaction fees inexorably to zero (this is just the start…)
These factors played themselves out (at least the first paradigm change) in the telecoms industry in the late 1990s through the turn of the century. With a delay of approximately 7 years, they seem to be playing themselves out in an eerily similar manner in the exchange space. I first wrote in March 2006:
…If you look at the LSE’s own historical data, the number of bargains per day in UK equities has increased consistently every year from 37k in 1994 to 212k in 2004 – approximately a 20% CAGR, and this through a period that included massive price volatility. In the previous 20 years the CAGR was closer to 5%, so clearly there has been a fundamental change. I think this underlying driver of this change has been the rise of automated and electronic trading. I suspect that you would find a similar pattern of accelerating volume growth accross most if not all financial exchanges.
I’m not suggesting that it would be prudent or appropriate to extrapolate this 20% or greater CAGR in trading volume into perpetuity, however I think that the convential wisdom (or sceptical wisdom) underestimates the potential for this growth to continue and perhaps even accelerate over the next several years. I think the more salient risk factor one needs to consider when looking at the prospects for exchange businesses is the degree of sustainability of pricing or margins as volumes grow and the entry-barriers for competitive alternative trading venues to emerge.
About that time I started comparing the share price performance of the exchanges with that of the late 1990 telecom companies, and asked the question here just over a year ago as to where this might be heading…
And yet, as the penny drops and the bubble bursts, (many of the leaders) of these august institutions are vainly protesting that it’s not fair and their perpetual competitive primacy and the associated profitability is assured in a world of ever increasing volumes. Ahem. Perhaps Ms. Furse should invite Mr. Bonfield for dinner to compare notes on how exponential growth in your underlying market doesn’t necessarily lead to corporate nirvana…
(via Bloomberg) “It was the right decision then and certainly now” to reject Nasdaq’s 1243 pence offer, said LSE Chairman Chris Gibson-Smith at a press conference today. “The current price doesn’t reflect the value of the company as we see it. If we deliver on some of the things, we’ll come back,” he said.
London Stock Exchange Group Plc has fended off five takeover attempts in the last 3 1/2 years, and shareholders may now be wondering whether all that effort was worth making. Yesterday’s closing price of 926.5 pence was lower than all but the first offer, made by Australia’s Macquarie Bank Ltd. in December 2005. Two days ago, the LSE fell below the lowest bid from Nasdaq Stock Market Inc., which made four proposals.
Have a look at this (apologies for the poor resolution):
This tracks first the share price of Sprint [S] from June 1993 to June 2003, and then the LSE from June 2001 to June (2011…) If the correlation holds, the LSE share price will be at around 450p in another year’s time, and at 300p in June 2011… I think it is equally obvious that the parallels are not identical; in particular the exchanges fundamental valuations (vs earnings/cashflow) were never quite as inflated as the 1990 telcos, nor did they leverage up massively and invest gigantic amounts in infrastructure (or spectrum licences…) That said I’d be pretty cautious about trying to catch these exchange knives just yet.
Addendum
This argument is not particular to the LSE. Indeed one only has to look at the price action of the CME, Deutsche Boerse, NYSE Euronext, etc. to see that it is somewhat generalized. The LSE however is perhaps particularly vulnerable and can fairly be accused (by shareholders at least) of not getting out while the getting was good…overplayed their hand I think is the expression.
Alas I haven’t made nearly as much money off of this as I should have; I dabbled in small shorts in the CME, DB and NYSE but was taken out by my trailing stops during the relief rally a few weeks ago. And I was lazy/greedy wrt the LSE so kept chasing it lower never getting filled. The easy money is probably behind us, but as I point out above I wouldn’t suggest trying to pick a bottom any time soon.
Furthermore, there is a real opportunity for the exchanges to learn from this allegory – they are not condemned to repeat (all) the mistakes made by the incumbent telcos…indeed there are exciting possible alternative business models for the exchanges that are more in phase with the new market paradigm. These however are daunting – if only that they require discarding long-held and until recently, highly successful approaches to the business and go to the core of what it means to be ‘an exchange’. What are they? Well, a boy has to make a living…I can’t tell all here. I wonder who will call first? 
