Here’s a short blue-chip pop quiz. Question one: what were the top three best-performing FTSE 100 stocks last year? Answer: high-street star JD Sports Fashion (JD.), IT giant Aveva (AVV) and – fortunately, for anyone who followed our 2019 Tips of the Year – the London Stock Exchange (LSE).
Bonus round: currently, what are the index’s three highest-rated stocks on a forward price/earnings basis? Answer: Aveva, technology conglomerate Halma (HLMA), and – once again – the LSE.
It is often said that the price for quality companies is a high one. For UK equities, this has rarely been more true, not least in the case of the main bourse on which those shares are listed. In 2019, three things happened to spark LSE’s considerable rerating: excellent underlying growth, the well-received $27bn (£21bn) proposed purchase of data services group Refinitiv, and an unsolicited $39bn bid from Hong Kong Exchanges and Clearing (HK:388), which marked the group’s shares at around £80 each.
Now, following a post-election rally, and despite the withdrawal of HKEX’s offer, the stock remains at a record valuation, on around 36 times this year’s expected net profits.
Arguably, this means one of two things. The first is that in an equity market starved of near-guaranteed growth stories, and backed by two decades of evidence, shareholders now believe corporate buyers for LSE exist at almost any price.
The second possibility, and a view shared by many City analysts, is that the Refinitiv deal represents a game-changer not only for the LSE, but for the wider global exchanges market, and that the current rich valuation disguises the massive synergies that can only come from the union of a leading financial data company and a top-five global exchange business.
In both cases, there are reasons for scepticism.
Peerless?
According to LSE’s own stock sector categorisation, investors should view the exchange alongside companies as disparate as wealth manager Brewin Dolphin (BRW) and manufacturing conglomerate Melrose Industries (MRO).
But a more appropriate peer group includes the global exchanges – CME (US:CME), Deutsche Börse (XTRA:DB1) among them – which have at some point all been linked with a takeover or merger with Paternoster Square. After all, these are the companies that would most benefit from the added scale a tie-up would bring.
Given that history, and the consistency of LSE’s earnings growth in recent years, it is not unreasonable for investors to expect that a bid might one day come from the other side of the Atlantic. However, the failure of HKEX’s bid is instructional, regardless of the poor execution, added political risk and offputting deal structure.
For one, there is LSE’s size, which even without the Refinitiv deal means an all-cash takeover is unlikely. Then there is the rating: on a price-to-book value basis, the LSE is at least twice as expensive as its larger US-based peers, according to S&P Capital IQ.
Indeed, the recent noises from the most likely acquirers are hardly compelling. “We always said cross-border transactions are very difficult to accommodate and to get done,” said Terry Duffy, chief executive of derivatives giant CME last summer.
New York Stock Exchange owner Intercontinental Exchange (US:ICE) – which weighed a bid for LSE in 2016, at the time of the latter’s failed tie-up with Deutsche Börse – also appears to have folded. Speaking about LSE in September, ICE president Ben Jackson said his company would err against such an enormous deal. “There’s been rumours over a long period of time around us and them,” he acknowledged, but pointed to Brexit-related uncertainty, valuations, ICE's own internal rate of return criteria and the nature of cross-border deals as risks.
Little room for error
A choppy track record for sector M&A appears to have been brushed aside in the case of the LSE-Refinitiv deal.
Investors have been told to expect the deal to complete during the second half of this year, but if regulators fail to approve it, the group could be on the hook for a £198m break fee.
But this week, amid LSE’s preparations to file its proposed deal with EU antitrust authorities, the Financial Times reported the tie-up has already faced “protracted discussions with Brussels over the scope of its investigation into the merger”. One potential area of regulatory concern is fixed income, in which both LSE and Refinitiv have large pre-existing markets, through their MTS and Tradeweb businesses, respectively.
Neither Refinitiv nor LSE expect to sell off any subsidiaries. But, even so, the transformation hailed by some analysts is only expected to translate to combined group revenue growth of 5 and 7 per cent a year.
Some are more optimistic. This month, Bank of America – in a note that described LSE as its “favoured long-term investment” in the sector – reckons Refinitiv’s growth rate should accelerate. Analysts at Redburn believe margins can also improve “under more focused, aggressive stewardship”. But this will need to offset losses in the financial terminals market, where ExaneBNP reckons Refinitiv’s share of the market declined from 30 to 22 per cent in the five years to 2018.
