This has been a tough year for the financials. The COVID-19 crisis caused a deep recession, which in turn caused the banks to take huge credit provisions for future losses, while the real estate investment trust sector was beset by volatility in the bond markets and struggling tenants.
Despite the huge rally in the overall stock market, the financial sector, as represented by the Financial Select Sector SPDR Fund (XLF -0.02%), is still down 6% for the year. One of the few financial stocks that has successfully weathered the storm is Nasdaq (NDAQ 0.14%). Does this outperformance mean that it is setting up for a fall? How risky is the stock?
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One of the two main stock exchanges in the United States
Nasdaq is a technology company that includes the Nasdaq stock market exchange, which is one of the primary U.S. stock exchanges (Intercontinental Exchange owns the other -- the New York Stock Exchange). The company operates four business segments: Market services, corporate services, information services, and market technology.
Market services includes cash equity trading, equity derivatives, and fixed income trading and clearing. Market services is the biggest of the four segments, accounting for 36% of net revenue in 2019. Corporate services, which provides listing and governance solutions, accounted for 20% of revenue last year. Information services is the sale of trading data, which accounted for 31%, and market technology accounted for the rest. Market services revenue is a function of trading volumes.
Strong trading volumes this year
The Nasdaq Composite has seen strong trading volume this year, especially in equity options trading. As a general rule, volatility in the markets translates into greater trading volume. The addition of new listings and initial public offerings has been a help as well. The big jump in Robinhood investors, who benefit from commission-free trading, this year has added to the volume spike as well. This year has been great for the equity exchanges in general, and investors shouldn't count on the party continuing indefinitely. That said, even in low-volume years like 2017, the company has still been profitable. It does have $3.6 billion in debt, but earnings before interest, taxes, depreciation, and amortization (EBITDA) covered interest expense over 16 times last year.
A new competitor looms
The Nasdaq Composite and the New York Stock Exchange (NYSE) are the two major exchanges in the U.S., and their model is difficult to replicate. Investors and issuers will generally flock to where the liquidity is greatest. There has been talk of a new competitor called Members Exchange (MEMX), which aims to offer a lower-cost alternative to Nasdaq and the NYSE. The launch process was delayed due to COVID-19 this summer, but the exchange went live on Oct. 29. It is still too early to tell if MEMX can take away share in cash equities trading from the incumbent exchanges, but it will be something to watch and does represent a risk to the company.
The exchanges have such a durable business model (insulating them from the overall economy) that the Nasdaq company should be regarded as one of the lower-risk financial stocks out there. Equities trading and clearing is a fee-based business that doesn't require the company to take credit risk, which is important during recessionary times.
Nasdaq is trading at 21 times expected 2021 earnings per share, which is in the middle to the high end of its range. Nasdaq is certainly at risk for multiple compression (that is, a falling price-to-earnings ratio); however, the risk of any sort of major financial distress is remote. It is a stalwart that will grow steadily, and its business will ebb and flow with market trading volumes.
