Here at Valuecruncher we are fans of Mark Weldon – the CEO of NZX.  We think that he has done a great job at NZX.  New Zealand’s capital markets are certainly in far better shape than they were before he arrived.  We view Mark Weldon as strategically sound and a good leader – he sets the direction and then lets his talented team (that he assembled) deliver the outcomes.

Last week NZX delivered their third quarter results.  We decided to have a look at the results and see what we think about the NXZ share price.

NZX Third-Quarter Announcement

The NZX result was very good.  Operating revenues were up 16% on the 2005 year-to-date period.  EBIT was up an impressive 34% on the year-to-date 2005 period.  These are some good results showing that NZX are growing the core business and generating better profitability.  The quarterly EBIT number was down 5% due to some big floats in the corresponding quarter in 2005 – not a big deal.

NZX also returned NZ$16.2 million to share holders in the quarter – because they did not need the cash.  This is a good thing – a company recognizes it doesn’t need all the cash it has and returns it to shareholders.  Too often we see companies unwilling to return excess cash to shareholders – and pursue non-core opportunities.  In our opinion – we have invested in your company for the business plan outlined and if you don’t need all the available cash then we are the ones to determine where it should be invested.  NZX should be applauded for this – the correct act.

So how did the media respond to the announcement?  The NZ Herald focused on the 11% decrease in net profit (http://www.nzherald.co.nz/search/story.cfm?storyid=000276D6-494A-1537-962F83027AF1010F).  They did note that interest income fell by one third – which is what happens when you make a positive move like returning $16.2 million in cash to shareholders.  Radio NZ and other media outlets also focused headlines on the 11% decrease in net profits.

This type of coverage must have driven NZX mad – you produce a good operational result and people focus on the “wrong” number.  Good operational numbers – see results from operational revenues and EBIT.  There is a drop in net profit – because we had less interest income from returning excess cash to shareholders.  If people have invested in NZX for interest income from cash held on the balance sheet – they have missed the point.  Headlines are about drop in net profit.  Just crazy – poor quality analysis all around.

To be fair to all media outlets – NBR were on the mark (http://www.nbr.co.nz/home/column_article.asp?id=16493&cid=4&cname=Business+Today).

So what do we think about the value of NZX shares?

A Valuecruncher valuation for NZX is included at the bottom of this post.

The assumptions we have made in the valuation are as follows:

We have assumed that revenues grow from NZ$19.5 million in 2005 by 20% in the 2006 year then 15% in 2007 and 10% in 2008.  This results in revenues of NZ$23.4 million in 2006, NZ$26.9 million in 2007 and NZ$29.6 million in 2008.  Three quarters of the way through the 2006 financial year NZX have revenues of NZ$16.4 million – 70% of the way to our NZ$23.4 million figure.

For EBIT we have assumed a 30% EBIT margin in 2006 and then 35% in 2007 and 2008.  This results in an EBIT of NZ$7.0 million in 2006, NZ$9.4 million in 2007 and NZ$10.4 million in 2008.  Three quarters of the way through the 2006 financial year NZX have EBIT of NZ$5.2 million – 74% of the way to our NZ$7.0 million figure.

We have assumed NZ$1.9 million of capital expenditure in 2006 – then dropping to a stable NZ$0.5 million per annum from 2007.

We have used the latest balance sheet numbers for the net tangible assets – removing the cash returned to shareholders and adjusting shares outstanding for stock splits.  We have also assumed that acquisitions recently made are NPV neutral for valuation purposes – i.e. acquisitions (for example FundSource) have been done at fair values.

Our mid-point share price is $3.24 – the current share price is $6.15.

Our valuation is 53% of the current share price.

Our valuation on a historic EV/EBIT (enterprise value/EBIT) basis is 12.0x compared to 24.1x implied by the current share price.  On a forecast EV/EBIT basis (using the Valuecruncher EBIT forecast of NZ$7.0 million for 2006) our valuation is 9.6x compared to a 19.3x implied by the current share price.  Those are some big multiples for NZX to be currently trading on.

Let us put those into some context.  TradeMe is located in the same building as NZX.  TradeMe was sold to Fairfax at a 26.9x historic EV/EBIT ratio and a 15.6x forecast EV/EBIT ratio.  TradeMe had an enterprise value of NZ$700 million based on the acquisition by Fairfax and NZX has an implied enterprise value of $135.4 million – which is interesting in that what is the most valuable “market” in New Zealand.  Also that each dollar of forecast 2006 EBIT is being valued higher for NZX (by the market) than by Fairfax in the acquisition of TradeMe.  TradeMe with 40%+ EBIT margins and growing at 9-10% a month.

TradeMe had EBIT in 2005 of NZ$26 million and forecast 2006 EBIT of NZ$45 million.  NZX had EBIT in 2005 of NZ$5.6 million and we are forecasting NZ$7.0 million for 2006.
NZX looks to be highly over valued at the current share price based on this analysis.  The fundamental discounted cash flow valuation is well below the current share price and the EV/EBIT ratios look out of line as well.

What is going on then?

Two possible answers:

1. We are significantly under-estimating the growth and earnings potential of the NZX business – the core New Zealand business (including early initiatives such as SmartShares), the acquisitions (i.e. FundSource) and the investment in Australia.  This is possible – and we have been conservative with our assumptions.  But to get to the current valuation levels suggested by the NZX share price we would need to be well below on our forecast numbers.

2. There is currently a wave of consolidation occurring in the major financial exchanges of the world.  The Australian companies ASX and SFE merged in July 2006 to create the world’s ninth largest financial exchange – we have used a rough merged model in our Valuecruncher analysis to show what the comparator looks like.  On October 17^th the Chicago Mercantile Exchange (CME) and Chicago Board of Trade (CBOT) announced a US$8 billion merger.  The London Stock Exchange (LSE) has been the subject of takeover proposals from Macquarie Bank and NASDAQ – in the last 12 months.  We have included LSE in our comparator set with our Valuecruncher valuation.

All this activity appears the result of the globalization of financial markets – heading toward ultimately global markets for all financial products with a lot of liquidity and low transaction costs.  Or it could be a defensive move by exchanges wanting to maintain price levels – and therefore profitability.  That is a big argument – with the jury still out.

This takeover activity has driven the valuations of these financial exchanges to historically high levels – based on the assumptions that there will be bidding wars by the major players to acquire these assets.  The markets appear to be factoring in these bidding wars to valuations of financial exchanges – including NZX.

NZX may be an ultimate acquisition target by a group involved in the consolidation playing out.  But the very small size of the New Zealand market compared to other exchanges means that NZX will not be a material asset for any of these groups – ASX has a current market capitalization of A$5.6 billion and NZX has a market capitalization of NZ$144.6 million.

The only logical buyers are Australian – ASX or Macquarie.  Or a speculative play by a hedge fund acquiring exchange assets in anticipation of being part of the consolidation.  But – at the current valuation levels NZX will look expensive to these players.  The market appears to be valuing participating in the global consolidation of financial exchanges in NZX’s share price.  Because of the small size of the NZX – compared to global players – we would think NZX will be part of the final mop up not an initial acquisition.

We think that No. 2 is the most likely scenario – and if global players decide to bid for NZX then the price might be reasonable.  But based on our analysis of the valuation of NZX – there doesn’t appear to be the underlying profitability to justify the current share price.

We like Mark Weldon – but don’t think NZX is worth what the market is saying.

NZX Valuation