Investment View: The LSE isn't for the faint-hearted but it's certainly a risk worth taking

 

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London Stock Exchange

OUR VIEW: hold

SHARE PRICE: 920P (-18.5P)

 

Following on from last week's look at three potential winners in the "Other Financials" sector, what of the London Stock Exchange (LSE)? Arguably this sector's most famous and visible member, it is also by a long way one of the hardest shares to rate, given huge number of intangibles floating around it.

The consolidation of exchanges into two or three mega-companies might appear to have come to a (temporary?) halt after EU watchdogs called time on Deutsche Börse's plans to merge with the New York Stock Exchange.

But there are still deals to be done, and the LSE remains in the thick of the action as it seeks to diversify its earnings away from what most people see as its core business: facilitating the trade in cash equities. Shares in other words.

When it comes to deals, I am a huge sceptic. There is no better way to burn shareholder value than through big-ticket mergers and acquisitions (M&A). Deals are often better for the executives who drive them (and get given extra bonuses packages for seeing them through) than they are for the long-term health and success of the businesses involved.

Not before time, institutional shareholders are waking up to this, and have in recent times torpedoed a couple of very big deals, namely Prudential's attempt to take over the Asian insurer AIA and the bid by the security company G4S to gobble up the Danish facilities management group ISS.

There are even rumblings of discontent about the commodity trader Glencore's vainglorious ambitions to merge with the miner Xstrata.

But that's not to say M&A should be ruled out entirely.

Take the LSE. The exchange is arguably in need of a deal or two now, and is still suffering from the effects of missing out on an acquisition, which initially appeared over-priced, a decade ago. That was Liffe, the London futures exchange, which was bought by rival Euronext, itself later taken over by the New York Stock Exchange.

The LSE has certainly improved its technology offering by buying a Sri Lankan IT operation. Snapping up the half of FTSE – which compiles indices – it doesn't own was another good move.

In future, the LSE hopes to improve its "post-trade" business (sorting out the back office and making sure all proceeds smoothly after a trade has been struck) through a deal with LCH.Clearnet, although the talks seem interminable. The exchange's ownership of the Milan Bourse has already given it a foothold in this area.

The LSE is also among the bidders for the London Metal Exchange, which will add a derivatives business (albeit a niche one). Derivatives are a part of the financial world where exchanges are seeing growth, not least because regulators want them to oversee trading in a lot of things that are currently handled off-exchange.

The reported £1bn asking price for the LME looks high – its profit was a pitiful £12.5m in 2010.

But it is seeing good growth and, bluntly, if you run an exchange, there aren't many other independent exchanges you can buy.

As for current trading, the exchange's recent update was well received, and the shares have responded with a rapid climb, although they are still a way off the highs they reached in July, before global markets went into a such a tailspin.

But the valuation is still relatively modest compared with historic standards, at about 10 times full-year forecast earnings with a prospective yield of 3.6 per cent.

Given all the uncertainties, I wouldn't be wading into these shares at their current level, but I would certainly hold, and buy some more if the stock succumbs to some profit-taking.

The LSE isn't a share for the faint-hearted, but if the chief executive, Xavier Rolet, can't turn the company into a star, he will likely sell. There will be no shortage of bidders.

The prospect of the LSE being a buyer first is a real one, and a deal for the London Metal Exchange could easily knock the share price for a while.

A risk worth taking. Hold.

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