Descended from 17th century London coffeehouse traders, today’s London Stock Exchange Group (LSE) is a major player among bourse operators. In our view, LSE's success will ride in good part on its ability to capitalize on recent and planned acquisitions – in indexes and clearing – to help fuel growth. We see LSE as poised to remain a competitive force in the continuously evolving exchange industry.
We expect LSE's information-services segment to continue providing the largest slice of overall revenue. Steady growth should be fed by appetite for index-based offerings, which are included in the segment's FTSE operations. In our view, the FTSE business, now fully owned by LSE, has an opportunity to build on the momentum of its selection as a benchmark provider to more than $200 billion of assets at Vanguard. We think the glow from this victory should help position FTSE to compete even more effectively going forward.
Indeed, indexes are going to become an even larger business for LSE, with the acquisition of Frank Russell Co. and its suite of index products. Separately, we also see potential in LCH Clearnet, in which LSE now owns a majority stake. We think this operation has interesting prospects, as clearing grows in importance, but we do have some concerns about recent customer losses and the business has been through a managerial transition.
The expansion in clearing and indexes is somewhat reducing the financial impact of LSE's capital-markets operation. Our expectation is that revenue gains at this still-key segment – which houses cash equities trading in the U.K. and Italy, derivatives and fixed-income trading and company listing fees – will be aided by a recovering European economy.
But the exchange industry remains competitive, the economic backdrop is unsettled, and we think investors should expect LSE to remain in a pitched battle for market share against key rivals. Additionally, we think movement in net treasury income from LSE's CC&G business – interest earned on cash and securities posted as margin and default funds – is likely to be more muted going forward, lessening its chances to lead to sharp earnings surprises.
What are the Shares Worth?
After lowering our cost of equity to 9% from 10%, we are increasing our fair value estimate for LSE to £22 from £19. Our revised estimate values LSE at about 18 times our projection for its 2016 adjusted earnings. Our valuation also implies an enterprise value/forward EBITDA ratio of about 11 times. We peg total revenue (total income, in the company's parlance) growth at an annual compounded rate of about 8% over the next five years, reflecting continued growth from its recent deals and sticky fee income.
Our projections yield margins on adjusted operating profit moving to around 41%-42%, while adjusted returns on invested capital should remain over our cost of capital estimate.
