Wednesday, April 27, 2005

Super Size Me!

On January 27th, 2005, Deustche Boerse AG (DB), operator of the Frankfurt-based stock exchange by the same name, formalized its bid of 530 pence per share for the London Stock Exchange (LSE). With this move, DB crystallized a process that began in 2000 and started a competition that could shape the future of European exchanges

In 2000, the two exchanges agreed in principle to merge, but those plans went awry as LSE was forced to fight off Stockholm Stock Exchange’s hostile takeover. The goal then as it was recently, was to create a pan-European exchange that would lead the continent in listed companies, IPOs, trading value and liquidity.

Additionally during 2000, the competitive landscape changed, signaling the start of a race to build Europe’s largest and strongest exchange. The Amsterdam, Brussels and Paris Stock exchanges merged to form Euronext, instantly creating the 2nd largest exchange by market capitalization in Europe (LSE 1st and DB 3rd). Two years later, Euronext merged with the Lisbon exchange and acquired the London International Financial Futures Exchange, the main UK derivatives exchange.

Against this backdrop, Deutsche Boerse’s bid for LSE was an aggressive play to stay competitive in Europe. Both DB and LSE are single country exchanges with no existing cross-trading tie-ups with other exchanges. DB publicly stated that their intent was to create the preeminent international exchange that offered one-stop shopping for securities trading in Europe (together they oversee ~ 40% of European stock market capitalization and 30% of all listed European companies). DB has a net income of slightly over 5 times that of the London bourse, but London offers more international companies, more liquidity and more IPOs. DB could use revenues from these sources to lower costs on trading and other fees for its trading participants.

Additionally, DB hoped that by joining with LSE, creating Europe’s largest exchange, other exchanges would look first to join with it when consolidation became inevitable. Also, DB wanted to use this tie-up to compete in the UK’s lucrative derivatives market through Eurex, the derivatives exchange it jointly operates with the Swiss Exchange.

LSE, however, felt DB’s offer did not represent the value of the combined company, given all the synergistic advantages that would be created by the merger, and twice rejected DB’s offer. LSE then invited Euronext to the discussion table in an attempt to encourage competitive pricing for its shares, hoping for an offer price of between 600 to 700 pence per share.

Faced with limited success of its offers, in late February, DB announced that it was considering a hostile bid for LSE. This created shareholder backlash among some of the funds that owned shares of DB. Shareholders wanted DB’s huge cash position distributed back to themselves in dividends or buybacks and not to be used in a takeover attempt that could decrease shareholder value. Faced with growing discord among some of its major shareholders, DB withdrew its offer for LSE in early March, however, saying it would re-enter the bidding process should another exchange make an offer for LSE close to the offer presented by DB.

Consensus abounds that any merger with LSE is set to rule the exchange landscape in Europe. Size is critical to survival as smaller regional exchanges opt to join the market leader when they consider consolidation. LSE and its partner would dwarf other exchanges in Europe and practically guarantee themselves as the first choice partner when smaller exchanges merge.

DB contends that the synergies created by a merger with LSE would amount to 100M€- 25M€ for cross selling revenue synergies and 75 M€ for cost synergies from operating from a single trading platform. However, analysts believe those estimates are overly optimistic, especially the revenue synergies. Furthermore, they state that since Euronext is more familiar with cross-boarder trades and has a business model that offers more synergistic opportunities, it is a better tie-up option. Analysts do not believe that DB’s strategy of using LSE’s equities trading position and Eurex’s technical experience with derivatives trading, to launch a market in FTSE and single stock UK-derivatives will work. Some say Euronext’s control of LIFFE and LIFFE’s liquidity will prove too significant a barrier for DB to gain any immediate foothold in the industry, such as it experienced in the US market.

Synergies of a DB-LSE merger do exist, mainly from the cost reduction of operating on a single platform. Revenue synergy from cross-selling is a less compelling argument. First, the national turnover in the UK derivatives market needed to support these synergies is hampered by stricter regulations in the UK than in Germany. Second, Euronext controls most of the derivatives trading liquidity through LIFFE causing difficulty for DB’s introduction of new products to steal market share.

In spite of these issues, DB should merge with LSE. First, Euronext is not better suited as a partner due to its cross-border trading experience. Before they merged in 2000, the three exchanges that make up Euronext were far more provincial than DB or LSE. DB can learn about cross-boarder selling as fast, if not faster, as those exchanges did. Second, as seen in the mergers among exchanges in Japan during the 90s and the recent merger between NYSE and Archipelago, the industry is consolidating. These consolidations occurred with exchanges that controlled the largest trading volume and value in the market. If DB wants to be an international exchange, built up through regional mergers within Europe, they need to be the largest European exchange offering the most liquidity, highest trading volume and value.

But how should they merge? Acquisition is the best option for DB. Along with being the largest exchange in a particular market, comes considerable buyer power. If DB’s management is concerned with creating long-term shareholder wealth for its current shareholders, it needs this power to control its future in a consolidating environment. Acquiring LSE will be a significant drain on DB’s cash position, but the long-term value is found in controlling strategy for the group and positioning itself to compete as an international exchange.

By Dan McKelvey, Jit Tan, and Jessica Zysk


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