Beware the Stocks Behind the Exchanges

by James Brumley | June 11, 2012 8:27 am

If you’re licking your chops over the dirt-cheap valuations of stock exchange names like NASDAQ OMX Group (NASDAQ:NDAQ[1]) or NYSE Euronext (NYSE:NYX[2]), you might want to keep your powder dry for a while. Why? Because an uber-cheap stock is only a bargain if the odds of future price appreciation are better than average.

In the case of stock exchanges, the future doesn’t necessarily look rosy.

Oh, on the surface they look healthy enough. Earnings for CME Group (NASDAQ:CME[3]) reached record levels last year, while the NYSE and NASDAQ are close to reclaiming their heyday revenue and profit levels from 2008. When you dig deeper, though — and focus in on the most recent results — red flags begin to wave. Worse, when the reasons for those red flags are brought to light, investors rightfully start to wonder if the problem is just too big to fix.

At the Heart of the Matter

To give credit where it’s due, last year’s per-share income of $17.04 was a big record-breaker for CME Group. The exchange — which focuses on new market-darling commodities like energy, metals and agricultural products — is drawing an expanding crowd of futures and options traders. Since more trading activity means more revenue and more traders means more trading activity, that’s roughly as it should be.

At the other end of the spectrum, though, conventional stock trading facilitated by the likes of NASDAQ OMX Group and NYSE Euronext is seeing a measurable — and significant — drop-off. Less activity means less revenue, which in turn means a challenged bottom line.

And make no mistake: Stock trading is falling out of favor. In 2009, an average of 9.77 billion shares of stock traded hands every trading day in the United States. It’s fallen every year since then, reaching an average of 6.71 billion shares (so far) for the current year.

In that light, it’s surprising to see these outfits even hold the line. The NASDAQ OMX company turned $3.38 billion in revenue last year into $387 million in profit, whereas the outfit did $3.68 billion in sales for 2008, generating a bottom line of $314 million. The NYSE did a little — though not a lot — worse on both fronts last year compared to 2008.

Given that stock-trading activity has fallen off by 30% during that time, though, the reasonably sustained results beg one question: How’d they even do as well as they have?

The exchanges don’t just make money by carving out a small piece of the action on every trade. Each of them also makes money by licensing data, collecting listing fees and so on. For the most part, each has done a pretty decent job of cultivating those profit centers while trading volume has withered away. It’s still not enough, however.

From Bad to Worse

Although diversifying and improving each of their profit centers was a wise move for the exchanges, the effort is kind of like bailing water out of a fishing boat with only a Dixie cup — conceptually it’ll work, but it’s not effective enough to keep the boat from sinking.

See, the people who no longer are interested in trading also are the ones who ultimately paid for that licensed data, or supported new exchange listings. Said more blatantly, if traders are getting out of the game altogether, why would they continue to pay for real-time quotes and the like? And in a similar sense, if investors aren’t all that interested in equities that already are listed on an exchange, why would a new company want to bother with the headache and expense of a NYSE or Nasdaq listing?

The problem is getting worse, too. Last quarter, both NYSE Euronext and the NASDAQ OMX Group fell short of analysts’ earnings estimates. The NYSE’s bottom line was nearly cut in half on a year-over-year basis. The culprit? Even-lower trading volume. And despite the buzz behind several recent IPOs, stock-trading volume for Q2 is on pace to be even lower than the first quarter’s total activity. Maybe that’s because many of those IPOs (and yes, I’m talking about Facebook (NASDAQ:FB[4]), though not just Facebook) ended up screwing so many investors[5], sending another batch of them to the sidelines for good.

No wonder NASDAQ OMX is only trading at 8.7 times its trailing 12-month earnings. That’s cheap, but it’s cheap because the future is looking less and less compelling.

Of the three exchanges in question, CME Group might be the only one we can really have any confidence in as things are right now.

Conventional stock traders are either getting out of the game altogether — which clearly is bad for exchanges that rely heavily on stock trading for revenue — or they’re migrating toward derivatives and commodities, which are right up the CME’s alley. All three names ultimately are at risk, however, as the number of active retail investors and proprietary traders continues to shrink across the board.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

  1. NDAQ:
  2. NYX:
  3. CME:
  4. FB:
  5. screwing so many investors:

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