TMXXF - TMX Group: Wait For A Pullback Before Buying This High Quality Business

2023-12-25 02:16:35 ET

Summary

• TMX Group, owner of the Toronto Stock Exchange, is a high quality business model with a near monopoly in equity trading and other financial markets in Canada.
• The company's revenues and EBITDA have grown significantly over the past decade, with strong profitability even during weaker economic periods.
• TMX Group's largest segment, Global Solutions, Insights & Analytics, has seen 19% year-over-year growth.
• Despite good top line growth, expenses have also gone up materially.
• At 21.6x Price to Earnings, shares look a bit expensive, so I would wait for a pullback before picking up shares of TMX Group.

Please note all $ figures in , not , unless otherwise noted.

Introduction

If you're a Canadian investor like me, you're probably familiar with the TMX Group ( X:CA ), which is the owner of the Toronto Stock Exchange and TSX Venture Exchange, playing a key role in financial markets in Canada. In addition to these exchanges, it also owns TSX Trust, the Montreal Exchange, TSX Alpha Exchange, Shorcan, CDCC, CDS, TMX Datalinx, and Trayport. This gives the TMX Group somewhat of a monopoly on not just equity trading, but also in the derivatives, currency, and fixed income markets in Canada.

As a for-profit enterprise, being an owner of exchanges is a good business. In normal markets, trading volumes (and by extension revenues from trading), tend to be fairly predictable. In periods of high market volatility, there tends to be greater demand for TMX Group's services like derivatives trading and clearing.

As well, exchanges tend to be highly regulated in Canada, regulated by the Investment Industry Regulatory Organization of Canada (or IIROC). As the main governing body, the IIROC basically ensures the exchanges and equity marketplaces follow the law when it comes to the rules set out by Canadian securities commissions. Along with the Canadian Securities Administrators (or CSA), they decide what is and isn't considered an exchange.

As you can probably imagine, it is extremely difficult to gain regulatory approval to start and operate an exchange. And it's not just the regulatory challenges which are a burden. The huge financial investment for critical infrastructure and the immense reputational advantage of existing exchanges make it extremely difficult for random exchanges to simply turn up, start operating, and accepting transactions.

But for the few exchanges that are out there (and TMX Group is an owner of several of them), they tend to be extremely profitable. Looking at the chart below, revenues and EBITDA have grown considerably, up 8-fold and 13-fold respectively, over the last decade. The company also has some pretty decent EBITDA margins well above 50% over this time period, indicating that the company is consistently profitable even during weaker economic periods.

Financials

When looking at TMX Group's Q3 results , the company reported that its revenues were up 8% to $287.3 million and that earnings per share was up 7% to $0.031 compared to results for the same period last year.

Most of the growth the company is seeing over the last little while has been in the Global Solutions, Insights & Analytics (or GSISA) business, which was up 19% year over year . This also happens to be the company's largest segment at 35% of revenues and has the highest operating margins of the segments at 63%. This segment includes its Trayport and TMX Datalinx businesses.

Trayport, which is basically the platform of choice for wholesale energy in Europe, has seen an acceleration in its growth rate so far with trader subscribers and total subscribers on the rise. As of right now, the company is guiding for "high single, low double-digit growth rate over the long term" but I believe that the recent results indicate that we could be on the higher end of that guidance, as firms amp up demand for data insights and algo trading products.

Despite higher revenues, one of the concerns I have going forward is the expense growth we are seeing for TMX as a whole. Looking at the table below, operating expenses were up materially (12%) year over year, particularly in the SG&A section, but was up only 9% comparably if we exclude BOXMarket expenses that occurred in the first half of the year but were recognized and recorded in this quarter. While management has stated that they intend to reduce expenses in the next few quarters, it will be important to monitor how the company manages expense run rate going forward.

Despite some near-term challenges with the expense control, TMX Group has a really solid balance sheet. At the end of the quarter, the company had a little over $550 million of cash and another $100 million of marketable securities. With a Debt to EBITDA ratio of 2.1x, the company looks to be in a decent position to maintain its debt with current cash flows. Most of the debt matures beyond 2028, so I don't believe there to be a near-term refinancing risk. Its interest rates on debentures are all under 4%, indicating the company has a fairly low cost of capital.

Valuation

When looking at the valuation of TMX Group, TMX Group is trading at a forward multiple of 21.6x Price to Earnings and at a forward multiple of 14.9x EV to EBITDA. Compared to its competitors Cboe Global Markets Inc (CBOE) and CME Group (CME) at 20.6x and 16.1x forward EV to EBITDA, respectively, TMX Group's relative valuation looks attractive. That said, in my view, these comparables are likely to grow faster than TMX given that they have more of a US presence, which is a faster growing market.

Based on the 8 equity research analysts with one-year target prices for TMX Group, the average target price is $32.46, with a high estimate of $34.82 and a low estimate of $29.85. From the average, this implies upside of just 2.32%, suggesting that the analyst community are also constructive on the stock.

When looking at analysts estimates for the stock, most analysts are expecting mid-single digit revenue growth over the next few years, so I can see why paying 21.6x Price to Earnings could be considered expensive. As a high quality company, it could be worth waiting for a pullback in shares, closer to the 17x earnings range, before picking up shares of TMX Group. Looking at the graph below, that also seems to be the mid-point of the valuation range where shares have historically traded, so it's not unreasonable to expect that we could get to that range.

Conclusion

TMX Group is a fantastic business with a dominant presence in Canada's financial landscape. To me, it's a legacy business that is subject to minimal disruption, given huge barriers to entry. This includes the substantial costs and infrastructure investment required to build out exchanges, the regulatory hurdles that prevent new exchanges from coming onto the scene, and the reputation and brand-awareness that TMX Group has built up by virtue of owning the largest stock exchanges in the Canadian market. As the company is seeing pressures at it relates to costs, I think it will be crucial to monitor how this develops over the next few quarters to see how that might impact margins and profitability. A high quality business model with impressive margins over 50%, TMX Group's shares aren't cheap so I would wait for a dip from the current price (which is close to 52-week highs) before making an investment today. For now, I rate TMX Group a hold.

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