John Thain, CEO of the NYSE Group (NYSE: NYX ) , is typecast as a technocrat -- MIT-trained, coupled with a cerebral approach. He will need all his skills to deliver on the near half a billion in technology savings promised by the acquisition of Archipelago and the planned merger with Euronext.
Thain is using technology to make up for time lost before NYSE filed for the IPO, when it was dominated by specialist interests. A reinvigorated Big Board is busy integrating Archipelago, rolling out the new Hybrid trading system, and planning a merger with Euronext. This transaction -- subject to regulatory and shareholder approval -- is scheduled to close in the first quarter of 2007 and will create the first global exchange.
Judging by last week's results call, this aggressive plan is going well. Total revenues for the quarter were up 10% to $470 million. The main driver was a 15% growth in trading volume at NYSE Arca, the newly acquired electronic trading platform. Operating income increased 23% to $94 million. This puts NYSE on track to deliver $200 million of expense savings, largely from technology, promised from the Arca acquisition by the end of 2007.
Creating a global exchange
Technology savings drive the Euronext deal. Out of forecasted annual savings of $275 million, $250 million comes from technology. The NYSE Euronext group will start life with six trading systems, 10 data centers, and four networks. Much of the duplication is at the NYSE, caused by the Archipelago acquisition and keeping human specialists -- despite every other major exchange going fully electronic years ago. NYSE operates four trading systems, including the Hybrid system, which it's still implementing, and a primarily automatic-execution system, with the option of specialist intervention. The merger plan calls for a streamlined technology architecture by 2009: One trading platform for cash equities, one for derivatives, four linked data centers, and one global network.
Technology even dominates the projected revenue synergies of $100 million a year. As NYSE's chief financial officer commented during the results call, the trading volume is low for the NYSE, relative to the market capitalization of the companies that trade on the exchange. Its trading volume to market capitalization ratio is one; the European exchanges have a ratio of 1.5, and Nasdaq (Nasdaq: NDAQ ) has a hyperactive 2.5. As NYSE automates and speeds up trading with its newly built (and acquired) technologies, trading volumes should multiply. To encourage this trend, the NYSE has announced new pricing schemes, taking effect in August, to lower trading fees.
Technology creates risks
Euronext will come to the deal with a strong record in merging and rationalizing technology -- and expectations to match. Between 2001 and 2004, Euronext took 10 trading systems -- six for derivatives and four for equities -- and rationalized them into two. And this was across four countries! Technical prowess translates into financial results. Between 2001 and 2006, Euronext grew its average number of cash trades at an annual cumulative rate of 13.5%, while its costs fell at an annual rate of 6.8%.
Euronext and NYSE even differ on how to source technology. NYSE gets its technology from SIAC, its two-thirds-owned subsidiary. SIAC provides technology to the Big Board at cost, on a non-profit basis. Other owner-customers include the American Stock Exchange. Euronext, on the other hand, operates its technology out of a for-profit joint venture with a leading French systems integration company, Atos Origin. The joint company is called AEMS and it sells software to 20 exchanges around the world. Because of AEMS, software sales make up 17% of Euronext's revenue. This arrangement has advantages: capital efficiency, as it shifts technology assets off the balance sheet and converts fixed IT costs into variable service costs. Interestingly, the CEO of AEMS has already stated publicly that he expects his revenue to double with the NYSE transaction. SIAC may be less excited about those growth plans.
Technology will drive NYSE's results over the coming years. Underinvestment in technology during the specialist-dominated era, combined with the luxury of choosing excellent platforms from acquisitions, provides the potential for outstanding results. Around $3 billion of market capitalization depends on technology savings from the Euronext merger. This calculation assumes a capitalization multiple of 25 and a discount rate of 10%, as NYSE used in its merger presentations (on page 40). And this is before valuing revenue benefits from technology and the ongoing savings from the Archipelago acquisition. To gauge just how important technology is to this deal, the new NYSE Euronext group is expected to have a total market capitalization of $20 billion, so at least 15% of NYSE's market cap depends on technology performance.
Thain has the opportunity to use technology to make NYSE Euronext the first (and dominant) global securities exchange. Success depends on his team's ability to manage the risks and returns of technology. Both the risks and returns are substantial.
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John Finneranis a consultant, investment analyst, and writer specializing in the financial value of technology. He does not own any of the shares mentioned. Feel free to email him. The Motley Fool is investorswriting for investors.