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LSE a weakling against TMX? Numbers don’t back it up

The TMX Group Inc.'s decision to get in bed with London Stock Exchange Group PLC has prompted anger among some bankers and politicians that the TMX, the fast growing resource market from the country with the strong economy, would dare marry up with a fading exchange from a country with serious problems.

Harris Fricker, a long-time investment banker and the head of GMP Capital Inc., says TMX should be the "diner," not the "dinner." The three banks that came out publicly against the proposed deal – Canadian Imperial Bank of Commerce, Toronto-Dominion Bank and National Bank of Canada – suggested in their letter last week that TMX "might restructure the deal in a way that better recognizes the TMX's current standing as a viable global exchange."

Politicians in Ontario's all-party hearings in recent weeks consistently asked why TMX isn't buying LSE instead of entering into a deal where LSE is the bigger partner. Some characterized LSE as a weakling relative to the TMX.

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By their telling, the TMX is the house in the up and coming neighbourhood, while the LSE is the manse in the once-grand street that's on the slide. Much of that seems to stem from the fact that LSE's market for junior companies, the AIM, is struggling, while TMX's TSX Venture Exchange is doing a booming business listing mining and energy stocks. TMX, and by extension, Canada, shouldn't settle for a deal where TMX shareholders get only 45 per cent of the merged company and one seat fewer on the combined board of directors than LSE.

At least that's the storyline.

The numbers don't back it up. Take away the emotions, and the fact is management and investment bankers look at two main things when doing a deal: relative size of the two companies and what each side brings to the table.

LSE is significantly bigger than TMX on a market value basis, and brings a lot of earnings and revenue to the table despite the perception that it's in decline. (A perception, by the way, that the numbers for the moment show is no more true of LSE as a whole than it is of TMX.) Looking at the income statements and market values, the proposed split of 45 per cent of the shares in the merged company to TMX shareholders and 55 per cent to LSE shareholders, along with almost half the board, isn't a bad deal for the Canadian company.

Before the proposed deal, TMX was worth about $2.9-billion, while LSE was worth about $3.8-billion. (All the figures from LSE have been converted to Canadian dollars for ease of comparison.) That's about 43 per cent of combined market value coming from TMX.

Looking at the earning power of the companies, LSE remains much larger. The company is much more than the faltering AIM. There's still the main London market, as well as the Italian stock market and a growing bond business.

The consensus estimate for 2011 revenue at TMX is $623.7-million. For LSE in its next fiscal year, which will end March 31, 2012, the consensus is $1.05-billion, according to Bloomberg. The fiscal years don't match exactly, but exchange businesses aren't so seasonably variable as to render the comparison off base.

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That means that TMX will be contributing about 37 per cent of the revenue of the combined company in the next year.

In terms of earnings (measured before interest, taxes, depreciation and amortization), the estimate is that TMX will pull in $367-million, while LSE will generate $581-million. So TMX will be contributing about 39 per cent of EBITDA. On a net income basis, TMX is expected to contribute 46 per cent.

But wait, isn't TMX growing so much faster that it will soon be a much bigger share of the combined company? Sorry, no. This coming year, analysts peg revenue growth for TMX at about 8 per cent, and for LSE at about 5 per cent. Look out another year and both are expected to post growth just shy of 6 per cent. As for the net income mix, analysts don't expect it to shift significantly.

Much has been made of the fact that LSE is losing market share in equity trading. But TMX has had to fight for it as well. On equity trading, LSE claims about 64 per cent of U.K. listed equity volumes, while TMX's equity trading market share in Canada is closer to 70 per cent.

However, LSE's markets are still busier in aggregate. LSE reported a total of 25.4 million equity trades in February on all its markets, compared with 17.9 million on TMX's markets.

There are some less tangible issues. TMX has a better business in derivatives, thanks to its purchase of the Montreal Exchange. TMX also has Canada on its side, home to a solid economy, a wealth of resources and a government with decent finances. LSE has none of those in its home country.

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Still, the numbers are the numbers. Too many favour LSE Group to come to the realistic conclusion that TMX should be the buyer at this point in time.

There may be an argument that TMX should be more of an aggressor, but if TMX is going to dine, it's not going to be dining on LSE Group. It's going to have to look elsewhere for something to eat.

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