With the New York Stock Exchange hitting key milestones this month on its way toward increased electronic trading, speculation abounds about the long-term impact on the specialist firms that have traditionally ensured a fair and orderly market in NYSE-listed stocks.
On Monday, the largest independent specialist, LaBranche (NYSE: LAB ) , reported lackluster earnings that did little to bolster visibility or confidence regarding its prospects in the rapidly changing U.S. equity markets. With the stock more than 50% below its 52-week high, I thought I'd take the opportunity to ponder whether this LaBranche could bear fruit for value investors.
First things first. Once the $17.6 million gain on NYSE Group shares is removed, LaBranche's third-quarter loss was $0.03 (year over year, as all of the figures discussed here will be, unless stated otherwise) per diluted share on revenues of $125.4 million. That falls well short of the consensus estimate of $0.12 per share in profit.
The company's cash equities business -- essentially, facilitating trading in NYSE and AMEX-listed stocks, which is also its dominant activity -- surged with respect to the second quarter, but net gains on principal transactions of $45 million were still 4% lower year-on-year. Commissions were also pressured, suffering a 17% decline.
In a difficult operating environment, LaBranche management looks determined to control costs and manage its balance sheet carefully. Employee and compensation costs were lower by 22%, and CEO Michael LaBranche voiced his intention to de-lever the balance sheet to reduce onerous interest costs. The company has the flexibility to do so since free cash available is set to increase by $225 million over the next three quarters because of a $170 million-$180 million decrease in regulatory capital requirements and the lifting of restrictions on $50 million in NYSE Group shares held by LaBranche.
Specialists under assault
LaBranche continues to look for opportunities to apply its technology and trading expertise to new markets and products -- as seen in its partnership with the Chicago Board Options Exchange to launch the CBOE Stock Exchange. However, I'm concerned that the company will never generate the fat profits it earned in its heyday, when its clubhouse was better insulated from outside forces in the U.S. equity markets.
For one, the NYSE is in the final phases of rolling out its Hybrid Market, which is based on an automatic execution system called NYSE Direct+. Previously, this platform accepted orders of only up to 1,099 shares, but customers will now be able to automatically execute orders of up to 1 million. Right now, NYSE Direct+ represents 17% of average daily share volume, but this number should increase materially.
This sentence from the NYSE Group's website sums up the threat to LaBranche succinctly: "The Hybrid Market automates much of what specialists do today, helping them become more efficient at the point of sale." While the Hybrid Market can be viewed as an opportunity for specialists to focus on higher value-added order executions, the relative size of that market compared with the specialists' previous dominion over almost all trading can't be determined yet.
What's more, the NYSE will need to comply with the SEC's Regulation NMS, which will be implemented in 2007. Reg NMS is a fundamental new set of regulations, including the "Order Protection Rule" -- also known as the "trade-through rule" -- which mandates that trading centers take steps to avoid executing orders at prices that are less favorable than quotations at other market centers. In September, the Nasdaq's (Nasdaq: NDAQ ) matched market share of NYSE-listed issues reached a new high mark of 12.9%, up from 7% in February. Reg NMS could further chip away at the exchanges' market share in their own listed stocks.
Between the NYSE's new Hybrid model and Reg NMS, it's clear that the playing field between different market participants is being flattened and that the specialists' moat is under massive assault. With much uncertainty surrounding LaBranche's operating environment, the market's response to its earnings announcement was anything but ambiguous -- shares lost almost 18% while the S&P 500 was essentially unchanged.
While the share price is there for all to see, trying to estimate its value is a real challenge. Instead, we can apply Legg Mason (NYSE: LM ) strategist Michael Mauboussin's framework to reverse-engineer the assumptions that would justify the closing price on Oct. 17 of $8.81 using a discounted-cash-flow model. (Check out Nathan Slaughter's book review of Mauboussin's Expectations Investing.) Here is one possible solution set of assumptions that is consistent with that price:
- Excess return period: Eight years
- Growth rate during the excess return period: 5%
- Net operating profit margins: 17.5%
- Cost of equity: 15%
Operating profit margins of 17.5% are very low by historical standards, but again, I'm not convinced that the company will ever return to its historical levels of profitability. (Pro forma operating margins for the first nine months of 2006 were 14%.) Michael LaBranche says early indications are that "profitability has not been affected" by the Hybrid Market, but if the current status quo persists, there could still be some downside to owning these shares. On the other hand, if one believes that LaBranche is a turnaround candidate, rosier scenarios do exist. Maintaining the above assumptions and varying operating profit margins, here are two possible valuations for the stock.
Scenario 1: Partial Turnaround
Scenario 2: Successful Turnaround
Net Operating Profit Margins
Intrinsic Value Per Share
As a value investor who practices a focused approach to investing, I'm not interested in owning LaBranche shares. To quote Warren Buffett, "When we look at a business and see lots of change coming, nine times out of 10, we're going to pass." With the equity markets undergoing transformation, I just don't know what the business of specialists such as LaBranche or Spear, Leeds, & Kellogg -- part of Goldman Sachs (NYSE: GS ) -- will look like in three or four years' time, let alone 10 or 15. I wouldn't fault risk-tolerant investors for taking a look at LaBranche at these levels, but it should be considered a speculation, not an investment.
Finally, I strongly believe that the exchanges themselves, particularly the Nasdaq and the NYSE, are better positioned to capitalize on the disruptive changes at hand.
- VDM's Not So Special(ist)
- Foolish Book Review: "Expectations Investing"
- Technology Takes Over the NYSE
- The Specialist Gene
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NYSE Group is aRule Breakers recommendation.