NYSE Euronext (NYX) is wasting little time lamenting the failure of the Deutsche Boerse (DB1) deal. After a year in which much of the company's attention was on completing this transaction, its focus is now firmly on the future. We are encouraged by NYSE's plans to lower expenses, and we think the exchange operator's pursuit of additional technology-related revenue can be beneficial to its narrow economic moat.
The company's latest expense-management initiative should help offset the negative effects of weak trading volume, and technology and information services have the potential to create more sticky revenue than NYSE’s trading-intensive operations, in our view. All in all, we think there is good upside to the shares. The stock was recently trading at about a 24% discount to our fair value estimate of $36 per share.
But internal growth and expense cuts are only a partial cure for NYSE's current volume woes. In the aftermath of the Deutsche Boerse misfire, we do not view large-scale, company-altering mergers or acquisitions as very likely in the near future. Smaller deals, though, are very much a possibility as NYSE management looks to meet its ambitious growth target for its information services and technology businesses, which would have the segment's revenue more than doubling from 2011 levels. In addition, this year we expect NYSE to complete the remaining $550 million in its stock buyback authorization, which we think will give some support to the shares. We view a dividend increase as less likely, as the company appears to view the current level as appropriate. Additionally, the company may exit some of its minority investments, which could free up cash that could be deployed in more strategic ways.
Tightening the Belt
We like NYSE's focus on controlling costs, as we think this will mitigate the effect of weak trading volume. The company expects to shave $250 million per year from its cost base by 2014. In general, we think the target is achievable, though it does carry some execution risk as management will have to be disciplined.
Of the $250 million, 72% ($180 million) will come from savings in technology and in organizational and infrastructure efficiencies, with the remaining $70 million coming from business optimization efforts. The cost-cutting effort probably won't come free, as we would expect some level of nonrecurring restructuring charges will have to be incurred. Moreover, NYSE also expects to book expenses related to new business initiatives. For instance, "core" expenses in 2012 are projected to be $1.58 billion-$1.60 billion, but initiatives in areas such as clearing and technology will push the expense total to as high as $1.65 billion. Still, our conclusion is that we like management's resolve to push the core expense base lower. The company has pledged transparency as far as providing updates on its journey toward the $250 million goal, and we will monitor its progress.
Looking to Technology Amid Tepid Trading
Through March, NYSE's figures showed trading in U.S. cash products, such as equities, down 18%-24% from 2011 levels. While the pace of activity may improve, we do not think 2012 will suddenly morph into a very robust year. However, we expect trading activity will return to more normal levels eventually.
In our view, a thicker book of business in technology services may provide NYSE with a revenue stream that is stickier and less volatile. NYSE officials have set a goal to boost revenue from information services and technology solutions--one of the company's three business segments--to $1 billion by 2015.
That would represent a big jump from recent levels, as the segment contributed about $490 million in revenue in 2011, and the acceleration in growth needed to reach $1 billion may well need an acquisition. But we think NYSE can get relatively close to its goal internally. To actually get to $1 billion by 2015, we think NYSE probably would need to complete an acquisition. At this point, we are not explicitly modelling for this, but with the proper acquisition in place, we think $1 billion is probably achievable. It will require a good deal of management's attention, though.
The technology markets targeted by NYSE include areas such as trading infrastructure as well as front-office needs. As the company makes progress, we think the added revenue may bring moat benefits. In 2011, according to the company, 84% of the technology revenue pie was made up of recurring revenue. Stanley Young, CEO of NYSE Technologies, believes this portion eventually can climb to 90%. NYSE aims to secure longer-term contracts that are not easily switched. Over time, we believe this will help bring higher-margin revenue to NYSE, which will improve returns.
