Friday, December 16, 2005

A Market in Electronic Trading

The Wall Street Transcript has just published
its Brokers and Asset Managers issue, a report offering a timely review of the sector to serious
investors and industry executives. This 54-page feature contains an expert roundtable forum of leading
industry analysts, and industry commentary through in-depth interviews with top management from 9
firms. The full issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.
Topics include: Impact of NYSE/Archipelago merger, Continuing industry consolidation, Regulatory
environment, Changes in options trading, Proprietary trading, Impact of Hedge Funds and ETFs on the
fund industry, Trade execution platforms and exchange companies, Stock picks, Stocks to avoid.
Companies include: Morgan Stanley (MWD); Friedman, Billings, Ramsey Group INC. (FBR),
Internet Capital Group INC (ICGE), Merrill Lynch (MER); Alliance Capital Management (AC);
Gamco Investors Inc. (GBL), Lehman Brothers (LEH); Knight Capital Group (NITE); Investment
Technology Group (IGT); Goldman Sachs (GS); E*TRADE Financial (ET); LaBranche (LAB); AGF
Management Ltd (AGF:TSX), Archipelago Holdings (AX); Ameritrade (AMTD); Instinet (INGP);
Integrated Assett Management Corporation (IAM:TSX), Gladstone Capital Corporation (GLAD),
Nasdaq Stock Market (NDAQ); MCG Capital Corporation (MCGC), Legg Mason (LM); T. Rowe
Price (TROW); Franklin Resources (BEN); TradeStation (TRAD) Utek Corporation (UTK). Analysts
Include: Richard Herr, Keefe, Bruyette & Woods; Robert Lee, Keefe, Bruyette & Woods; Lauren
Smith, Keefe, Bruyette & Woods, Rachel Barnard, Morningstar.
In the following brief excerpt from the 54 page report, Richard Herr discusses the realignment in the
exchange and electronic trading area - and the outlook for the sector and for investors.
TWST: Rich, give us your take on the online brokers you follow. Have they shown the same kind of
Mr. Herr: Yes. This has been quite a year for many of the companies I cover in terms of price
performance. The online brokerage sector has not witnessed this degree of change in the last several
years. Much of this change has largely been due to mergers. In June, Ameritrade (AMTD) announced
that they would be acquiring TD Waterhouse from Toronto-Dominion Bank (TD). Although the
transaction was announced in June, news of a possible deal had been in the financial press for more
than a month. We witnessed an expansion in price/earnings valuations in the shares of many online
brokerage stocks based on the belief that a significant amount of overcapacity in the industry is being
removed through consolidation. Similarly, in August, E*TRADE Financial (ET) announced that it
would acquire Harrisdirect, and in September, announced the acquisition of Brown & Company.
Perhaps some of the most significant consolidation activity has occurred among the US exchanges. On
April 18th, the New York Stock Exchange and Archipelago Holdings (AX) announced they had
agreed to merge. Through the transaction, the New York Stock Exchange would become a for-profit,
public company. By the end of the week, Nasdaq Stock Market (NDAQ) announced that it had agreed
to acquire Instinet (INGP).
The announced transactions in the exchange sector have similarly aided a significant improvement in
terms of price/earnings multiple valuations. In addition, there is a significant amount of secular change
occurring in the industry, in particular through equity trading. In April, the SEC passed Regulation
NMS, which requires that much of the trading on the equity exchanges be conducted electronically by
mid-2006. Among the many direct and indirect implications of the SEC's ruling, the most tangible is
our expectation to experience an increase in trading volumes in 2006 and for the next few years
beyond. So while the markets have been somewhat sideways and equity-trading volumes have been
only up slightly year on year, secular changes as well as the mergers and acquisitions occurring in the
space have largely propelled the positive stock performance.
TWST: What are the time frames on some of these acquisitions for the New York Stock Exchange and
the NASD?
Mr. Herr: The New York Stock Exchange and Archipelago merger is expected to occur during early
Q1 of 2006. I think that may be somewhat optimistic; we believe it will probably be more in the
February/March time frame. The New York Stock Exchange member vote is to occur on December 6,
2005, and our expectation is the deal will be approved, paving the way for a Q1 close. Nasdaq expects
to close on the Instinet transaction in December 2005, which is a far simpler transaction. The
Ameritrade/TD Waterhouse deal is expected to close right around the same time - December 2005 or
early Q1, 2006. E*TRADE has been doing much smaller acquisitions. They've already closed on
Harrisdirect announced in August. The Brown & Co. deal should be closing before year-end. So
between now and the end of the first quarter, we should see a lot of significant deals getting
TWST: Will that get a sigh of relief on the part of everybody?
Mr. Herr: Well, it will clear up a lot of uncertainty as to how the new, combined companies will look.
Once these transactions are actually completed and management is able to speak more openly about
their expectations for their strategy going forward, that will help support current valuations.
TWST: Richard, your space certainly has been active from an M&A point of view. Is it over?
Mr. Herr: I get that question a lot. I would think that in terms of large, online brokerage transactions,
we are in the later innings simply by virtue of the fact that there just is not much left. Privately held
Scottrade is the one independent online broker of significant scale that could consider a sale if the
price were right. However, in terms of the public domain, a lot of the transactions have already taken
Looking at the exchange and some of the trade execution companies, I would not rule out further
consolidation. We have had the two large ones take place already, those being New York merging
with Archipelago and Nasdaq acquiring Instinet. However, I think there is some other activity on the
horizon in terms of some other exchanges looking to go public, and I think that further down the road,
there could be consolidation opportunities. Looking at some of the regional exchanges - the
Philadelphia Stock Exchange and the Boston Stock Exchange in particular have taken outside capital
investment. We believe that further down the road, outside capital is going to look for an exit
opportunity in the form of either an initial public offering or possibly by selling prior to an IPO.
However, the recent trend appears to be, first, go public and establish a public market value, and then
explore strategic opportunities. So within the exchanges, we are in the very early stages of the cycle.
In fact, within both equity and derivative exchanges, it's only starting to heat up now. That's why
there's so much money flowing into the space.
Some of the other names in my space such as Knight Capital Group (NITE) or Investment Technology
Group (ITG) are companies that have really made significant turnarounds in their businesses over the
last year or year and a half, largely as a result of excellent management execution. However, over the
longer term, I think that these companies may be better served as a part of larger institutions. It may
not be a 12-month issue, but in 18 or 24 months, it may seem reasonable for them to be exploring their
strategic alternatives.

This 54-page special issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online .

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