Financial Jungle

On the surface, TSX Group appears as a textbook play for a fundamentally sound company with a distinct competitive advantage in the Canadian equity exchange market. The company has a strong cash flow, no long-term debt, and sports an attractive 3.5% dividend yield. It owns the only senior equity exchange (the TSX) in Canada, and is poised to penetrate Montreal Exchange’s lucrative derivate market as soon as the 10-year exclusivity agreement expires.

Back in 1999, TSX Group shook hands with Montreal Exchange (MX) in a deal to gain exclusive rights to equity listing. In return, the TSX handed over all options and derivatives trading to MX for the next 10 years. The 10 years was almost up, and things were looking rosy for TSX, so I picked up a position at a rock bottom price during the 2006 summer correction.

Fast forward a year later, TSX’s outlook doesn’t look so rosy anymore, but I’m still holding on to the position. In early May, a group of Canada’s leading investment dealers announced a plan to launch a new Alternative Trading System to take a bite out of TSX’s trading business. Good for them and lousy for me. To put that into perspective, the trading business represents about 40% of TSX’s total revenue pie in the previous fiscal year. It’s nothing to sneeze at, but CEO Richard Nesbitt predicts the proposed ATS would eat up a paltry $3 million out of the projected $400 million in annual revenue. Assuming he’s being optimistic, I’ll take that as the best-case scenario.

Let’s turn the page over to TSX’s bread and butter, equity listing department. Off the top of my head, I can’t remember the names of the recently consolidated TSX listed companies, but BCE and Alcan are likely the next 2 big boys on verge of getting taken out, and a number of analysts are promising more to come. Amidst all the consolidations, many Canadian companies are also inter-listing their stocks across the border, which makes me deduce it’s a matter of time before TSX’s equity listing revenues growth begins to erode.

Last night, I received a fresh copy of Investor’s Digest. The timing is impeccable, because Larry MacDonald wrote a piece on TSX Group with an exact opposite opinion. Now, Larry MacDonald is a lot smarter than I am, so I’m willing to bow to his wits. Some of his key counter-arguments are as follows:

He said TSX Group is the perfect welcome mat for BCE refugees looking for strong yields. I think he makes a good case, although one would think that BCE shareholders would either go with Telus or Rogers as an alternative telecom play, or Bank of Montreal as an income play.

TSX Group “enjoys a near monopoly on stock trading in Canada. Put another way, the company enjoys pricing power and exposure to the secularly booming commodity market. That would seem to make it an attractive alternative for investors wondering what to do with the proceeds from takeovers of resource companies.”

“TSX Group has a dividend yield of 3.5% that is well supported by ample, steady cash flows and a clean balance sheet with no debt and about $300 million in cash.”

“The new ATS is not expected to be up and running for at least a year.” TSX Group is leveraging a 12-month window to develop a faster and more cost-efficient trading platform, in addition to slashing their trading fees in attempts to keep the ATS threat at bay.

“The New York Stock Exchange was even more outmoded than the TSX, but it still flourished though a decade of competition from electronic and other alternative exchanges. Incumbency is a huge advantage in the stock exchange business.”

I apologize if I’m not offering a definitive conclusion. I take selling very seriously especially when much of the bad news has already been absorbed in the share price. The 3.5% yield should set a floor price, although the 22 P/E is probably steep for a stock facing serious head winds in revenue growth. In the meantime, I’m staying put and watching how events unfold over the next 12 to 18 months.