Description

·         Eurex division (47% of 08 EBIT) gives DB1 a large exposure to the trading and clearing of derivative instruments, a key secular growth driver because of:

o    Increased use of derivatives by corporates and mainstream institutional investors thanks to more accommodative regulations (e.g. UCITS III in Europe)

o    The migration of OTC derivatives trading and clearing to exchanges

o    The creation of new contracts

·         Clearstream (34% of 08 EBIT), should also be an important growth contributor given the increase in public debt to be issued in the future.

·         Valuation is attractive at 9% 2009 FCF yield and 12.2x 2009 PE on conservative numbers already accounting for a volume drop at Eurex.

Key Financials:

DB1 shares have fallen 60% from their highs. Similarly, its consensus forward PE has contracted from 24x to 10x

·         Revenue drop at cash exchange Xetra: Xetra, the exchange for German equities is under pressure from MTFs (multilateral trading facilities), the new generation of electronic exchanges such as Chi X. Xetra is losing incremental volumes and market-share and has lowered its fee structure to in a bid to fight against the new exchanges resulting in EBIT dropping 22% in 2008. However, Xetra only accounts for 14% of EBIT.

Current Valuation

Due to its high margins and low capital intensity, Deutsche Boerse generates close to €1Bn of free cash flow for equity holders, resulting in a 9% yield. Unlike banks or insurance companies, it does not take credit risks and is not subject to write-downs.  On our lower than consensus numbers, the current trading multiples are:

DB1 has 5 business lines: (1) Eurex, (2) Clearstream, (3) Xetra , (4) Data and (5) IT. The first three are the most important to its earnings.

1)       Eurex is the exchange for derivatives on equities, indices and interest rates.

·         The future of Eurex is promising, benefiting from a secular increase of the use of derivative instruments by investors and corporates. The recent disruptions in the markets are pushing market participants to clear and eventually trade OTC transactions on an exchange. Furthermore, in the long term, derivative exchanges have optionality on contracts on new asset classes such as carbon emissions or shipping.

·         Long term volume increases should far outweigh any fee compression. The barriers to entry for derivatives exchanges are much stronger than for cash exchanges. Unlike cash transactions, a solid clearinghouse is crucial for derivatives transactions which can stay opened for years. Derivative exchanges have their integrated clearinghouses, and new electronic exchanges do not have the capital to create a new one. Since 2002 volumes have tripled, average fees have been stable, and costs have increased by 70%. The EBIT margins are at 62%.  

·         In the short-term, I am modeling a 14% drop in volumes for 2009, as I assume a material slowdown in hedge fund flows due to deleveraging. I assume that 55% of the orders were coming from hedge funds and assume that the 33% reduction in AuM (average 08 vs. average 07) will translate in an equivalent slowdown in volumes, compensated by a 10% growth in volumes from “plain vanilla” accounts resulting in a 14% overall volume decline.

·         In the medium-term I estimate that volumes pick up again at 10% in 2010 and 2011, and 8% in 2012 and 2013. To put things in perspective, between 2002 and 2008 volumes have grown at 18% organic CAGR, mainly driven by hedge funds.

2)       Clearstream settles and ensure the custody of fixed income securities worldwide, as well as German equities. It charges a settlement fee per transaction, and a custody fee based on the assets under custody. In addition, it receives interest income on the funds it holds overnight on the behalf of its clients. Its closest listed peers are the US banks such as Bank of NY or State Street. Clearstream is perceived to be a stable business. While the deleveraging may have an impact on the number of transactions settled, and depressed asset prices do affect fixed income securities under custody, renewed issuance of public debt will provide support to the business.

3)       Xetra is the weakest division of DB1. Xetra is the cash trading business with sales down 15% from 08 to 09. It is suffering from fee compression and market share loss against the MTFs (Chi x, BATS..). It accounts for no more than 15% of EBIT. Management sees this business as core and is against a disposal.

4)       Two more divisions, Data and IT are not a meaning full earnings driver accounting each for 7% of EBIT

Costs:

·         DB1’s largest cost is staff (42% of total in 2007) which is essentially fixed. Between 2002 and 2007 DB1 has employed between 3,000 and 3,282 FTEs while revenues rose from €1.2Bn to €2.7Bn. Salary expenses increase as a function of inflation as well as DB1 stock price because of option plan expenses. Management does not expect to materially add employees next year.

·         Other costs are IT (13%) and banking commissions (13%).

·          Long-term capex is €110, or c. 4% of sales and mainly consists in development of trading and connectivity systems.

·         Management may conduct some unexpected M&A:

While some activists fund would prefer to see DB1 broken up to reach a sum of the part valuation, Management may try to acquire a smaller exchange, postponing an immediate realization of value. However, those exchanges are all cash centered, currently not a priority for DB1 given the difficulties of those businesses.

·         On 8/12/08, Der Spiegel revealed that DB1 had considered a merger with NYSE. This would have been the largest M&A deal (in terms of personnel) in the exchange sector. NYSE has not fully integrated Euronext and Amex yet, and a transcontinental merger mixing eclectic national interests would have been hard to implement.

·         Large shareholder may face redemptions or give up:

Catalyst