With its recent acquisition of risk management and regulatory software specialist Adenza from private equity firm Thoma Bravo, Nasdaq (NDAQ -0.28%) continued its transformation into a leading technology provider to the financial industry.
However, after the announcement of the $10.5 billion deal, the market sent Nasdaq's shares down by more than 10%.
Compared to the company's current market capitalization of $26 billion, the $6 billion in additional debt it will have to take on to fund the deal seemingly has the market worried -- or, at least, skeptical about the premium that Nasdaq is paying.
So is the market's initial reaction correct, or should buy-and-hold investors see this sell-off as a buying opportunity?
History points to it being the latter.
Does the Adenza acquisition make sense?
Setting the price tag of Adenza aside, almost everything about this acquisition fits Nasdaq's long-term vision.
While it was historically reliant upon the volatile and lumpy trading revenue generated from its securities exchanges, Nasdaq has been on a decade-long transformation to become a recurring-revenue business. Adenza, which forecasts that roughly 80% of its $590 million in expected 2023 sales will derive from recurring-revenue sources, fits this narrative perfectly. Once the acquisition is integrated, Nasdaq's annual recurring revenue (ARR) will rise to 60% of its total 2023 estimated sales.
Furthermore, the financial risk management and regulated markets that Adenza serves are projected to continue growing at an 8% annualized rate for the indefinite future. A primary driver of this growth can be found in the 2010 Dodd-Frank Act, which reformed and enhanced Wall Street regulation in the wake of the Great Recession. According to a 2019 study conducted by Rice University's Baker Institute for Public Policy, in the years since Dodd-Frank was enacted, compliance costs at U.S. banks have increased by more than $50 billion annually.
With Basel IV's reforms being gradually implemented over the next five years to help stabilize the global banking system, Adenza's regulatory software is perfectly positioned to thrive. Adenza is expected to have sales increase by 15% in 2023, and with a dollar-based net retention rate of 115% -- meaning that its existing customers spent 15% more with the company in the past year than they did in the year prior -- it should provide Nasdaq with years of steady growth.
Best yet, Adenza's offerings complement Nasdaq's existing fraud and anti-money-laundering line, Verafin. By combining Adenza and Verafin, management expects to reap more than $100 million in annual cross-selling synergies as the units consolidate their customer bases and grow alongside each other.
Can Nasdaq absorb the purchase price?
Raising $6 billion in debt to fund the cash portion of the deal will more than double Nasdaq's debt load to roughly $11.5 billion. This will leave the company trading at a gross debt to adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio of 4.7.
Traditionally, most companies try to keep their debt-to-EBITDA ratios below 3, so this deal really will lever things up. However, Nasdaq's acquisitive past may, oddly enough, be precisely what helps it promptly absorb the high cost of this acquisition.
Having spent between $700 million and $3.7 billion each on four separate acquisitions since 2007, Nasdaq has a history of successfully integrating major purchases that it funded in part using debt. Furthermore, these acquisitions have combined to turn the company into a free-cash-flow (FCF) generating machine.
Data source: YCharts.
More than tripling its FCF over the last decade -- while revenue doubled -- Nasdaq has proven capable of growing through acquisitions while driving significant FCF-producing efficiencies. This FCF will help fund Nasdaq's biggest deal yet, providing stable and growing inflows that remained resilient -- even during 2022, when initial public offerings (IPO) came to a near standstill and took the wind out of Nasdaq's listing business.
Nasdaq is capable of deleveraging quickly, and plans to. Management expects its debt-to-adjusted EBITDA will drop to 4.0 after 18 months and 3.3 within three years. Furthermore, Adenza is expected to add more than $300 million annually in pretax cash flow of its own, meaning that the company may soon see its first year of over $2 billion in FCF.
Higher risk, higher reward -- now at a lower price
While the risk portion of Nasdaq's risk-reward ratio is undoubtedly higher now, the potential rewards that will come from adding Adenza's steady recurring revenue and double-digit-percentage growth rates make the stock quite alluring, particularly after its recent dip.
Data source: YCharts.
Trading at an enterprise-value-to-FCF ratio lower than it has seen since the March 2020 crash, Nasdaq, with its major role in the financial world and its market-leading IPO win rate, looks discounted.
Furthermore, management says it expects to continue increasing its 1.7%-yielding dividend, even with the higher debt load, as the payout only uses 26% of its FCF.
Thanks to this combination of a discounted valuation, steady FCF generation, a well-funded and growing dividend, and a promising new growth avenue, I will be looking to add to my Nasdaq position once trading restrictions allow.
