Newest Position: TMX Group
An excellent company trading at a fair valuation? Yes, please
I won’t bury the lede. I purchased shares of TMX Group (TSX:X) last week, momentarily interrupting my European vacation to do something productive for a change.
Sure, I enjoyed the sights and all the tourist traps in Europe (except for all the weed in Amsterdam. Enough already, guys), but I wasn’t about to forego an opportunity to research stocks in a whole new country. After a long day of figuring out where the hell I’m going and where to eat, I really enjoy going back to my room and enjoying the familiarity of investor presentations and income statements.
Feel free to mock me. My wife already has, as have most of my friends. Apparently annual reports are not what you’re supposed to do on vacation.
I also wrote the intro to this post on a train from Munich to Hannover. Apparently you’re not supposed to do that, either.
TMX Group is a stock I’ve been somewhat familiar with for years, but I’ve never owned it. I recently rediscovered it when it came up during a recent post, so I dove in. I liked what I saw and the rest is history.
Let’s take a closer look at this stock and I’ll explain what I think makes it an excellent business.
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The Toronto Stock Exchange has existed since 1861, when a group of brokers got together and created a formal stock exchange. Original trading hours were limited to a half hour per day and the trading list consisted of 18 securities, which meant there weren’t really that many trades.
The exchange grew and by 1901 the TSE was trading close to a million shares per day. The price for a seat on the stock exchange reached $12,000, and the exchange moved to bigger offices.
The price per seat rose to $100,000 by 1955 and in 1958 the TSE started to require formal disclosures from listed companies regarding anything that could influence the stock price.
1977 was also a significant year. That was when the TSE introduced computer assisted trading for the first time, as well as creating the TSE 300, which was the benchmark Canadian stock index for decades. That was followed by the Toronto 35, which was obviously modeled after the Dow Jones 30.
The new trading floor constructed when the TSE moved to its current location in 1983.
By the 1990s the TSE had moved ahead with a couple other practices that are common today, doing so before U.S. exchanges did so. They introduced decimal trading, getting rid of fractions. And they did away from the traditional trading floor, switching completely to electronic transactions.
A young Nelson visited the stock exchange tower in Downtown Toronto in 2003. I was pretty disappointed when I found out there was no open cry trading floor like the NYSE.
Throughout its history, the Toronto Stock Exchange had to compete with smaller provincial exchanges. Vancouver, Alberta, Winnipeg, and Montreal all had their own exchanges, each specializing either in local securities or a certain type of securities. Vancouver, for example, was the stomping grounds of so many shitty junior miners. Winnipeg handled commodities. And Montreal was, for a while anyway, the preferred location for Quebec companies.
By the 1990s it was obvious any company of size was listing on the Toronto Stock Exchange. So the exchanges got together and decided on roles for each. The Montreal Exchange would focus on options. The Vancouver and Alberta stock exchanges would merge (later joined by Winnipeg and some smaller exchanges) and list junior securities, calling the new exchange the Canadian Venture Exchange (CDNX). And the Toronto Stock Exchange would continue to be the home of large, established companies.
By the early 2000s it wouldn’t really matter anyway. The Toronto Stock Exchange would acquire the CDNX, rebranding the new organization as the TSX. This was to separate the exchange from Tokyo, which was also called the TSE. Then the TSX finally acquired the Montreal Exchange in 2007, changing its official name to TMX Group.
After some 150 years of being owned by its members, the TSX became a publicly traded corporation, listing its shares on its own exchange in 2002. It has spent the last 20 years slowly accumulating various other financial assets. More on that later.
In 2011, the London Stock Exchange and TMX Group announced they would merge, calling it a win-win for both Canadian and British investors. European companies would get access to Canadian investors, and vice-versa for local companies.
Before shareholders had a chance to vote on the potential merger, a consortium of Canadian finance companies came together and created Maple Group, which announced it would make a competing bid for the exchange. After the merger was defeated, Maple Group acquired TMX and merged it with the alternative Alpha Trading System and clearing house CDS Inc. The newly formed company was then relisted on the Toronto Stock Exchange.
The skinny today
These days, TMX Group is divided into four different divisions. I’ll list them below, along with their approximate revenue split over the last 12 months.
Global Solutions and Insight - 32% of revenue, 64% operating margins
Capital Formation - 24% of revenue, 42% operating margins
Derivatives Trading & Clearing - 23% of revenue, 58% operating margins
Equities and Fixed Income Trading & Clearing - 21% of revenue, 50% operating margins
Let’s take a look at each part of the company individually, starting with the largest. Global Solutions essentially sells data to various market participants. This portion of the company was recently boosted with the acquisition of Trayport, which sells data to traders, brokerages, other exchanges, and clearing houses, mostly in Europe. The technology is also key to many trading platforms, including one that controls most of power and gas trading in Europe.
This division is expected to grow revenue at 7-9% annually over time. It’s no Bloomberg, of course, but it is a way for investors to get a piece of a Bloomberg-like business.
Next up is the Capital Formation division which, as you probably guessed already, is the IPO market. It also includes secondary issues, debentures, and listing fees. This division, naturally, is more of a boom and bust business, with new stock issues increasing substantially during good times. But it still delivers a certain amount of stable cash flow even when the IPO market is tough, since it collects those sweet listing fees from 3,500+ TSX and TSX Venture Exchange listed companies. This division also owns TSX Trust, which has a 31% market share as a provider of corporate trust services.
Derivatives have quietly become a big business, thanks to lower commissions and online how-to tutorials, which have introduced options to the common investor. Assets in this division include the Montreal Exchange, the Canadian Derivatives Clearing Corporation, and a portion of Boston Holdings Group, the parent of BOX, a U.S.-based derivatives exchange. Transactions on the Montreal Exchange rose some 20% in 2021 compared to 2020, with that gain mostly maintained in 2022. Additionally, Montreal introduced some new products recently, including interest rate futures.
Finally we have trading fees. Only approximately 60% of trading happens through the TSX, with other solutions making up the rest. But the company is still the leader here, and is poised to benefit as both volumes and the number of issuers creep up over time. The number of trades processed has grown by 9% annually over the last 25 years, a growth rate I think is very possible over the next 25 years, too. A new generation of Canadian investors have discovered stocks. That’s a good thing for the stock exchange.
Essentially, it comes down to this. If a company wants access to the Canadian capital markets, they have to go through TMX at some point, and they will pay to do so. Even in an era where so many companies are staying private and raising money from large investors that way, it still represents a pinnacle of sorts to be listed on the Toronto Stock Exchange. I really like the moat here. Now all we have to evaluate is whether the company’s valuation is fair.
Why I’m buying today
TMX Group has been an excellent performer in its history as a publicly traded company. It has posted a double-digit CAGR since 2003, at least.
Strong gains in a stock are usually caused by improving fundamentals, of course. TMX Group certainly delivers on that front. The company has consistently grown revenue and earnings over time, all while only ever so slightly expanding the share count.
First, let’s look at revenue. 2016 and 2017 were a little rough, partly due to weakness in the commodity and energy markets. Things improved after that, as you can see below. Revenue in 2022 was a hair over $1.1B, or close to a 100% improvement since 2017.
Next up is earnings per share which, as you can see, trended higher from 2013 to 2017 as revenue remained stagnant. Earnings really exploded over the last few years. Note that I’ve put in normalized earnings, which gets rid of big swings caused by one-time charges.
Analysts expect normalized earnings per share of $7.28 in 2023 and $7.84 in 2024.
Shares outstanding did increase a bit over the last decade, increasing from 54.1M to 56M from the end of 2013 to 2022. There have been net share repurchases over the last few years, with shares outstanding peaking at 57M in 2020.
After keeping the dividend steady for a few years from 2012-15, the company started getting serious about increasing its payout in 2016. It went from $1.60 to $1.65 per share that year, increasing to $1.95 in 2017 and marching higher each year since. After raising the payout a couple weeks ago when it reported 2022’s results, TMX Group pays a $3.48 per share dividend. That’s good enough for a 2.6% yield today.
The company targets a 40-50% payout ratio. If the company does hit analyst targets of $7.28 per share in normalized earnings in 2023 that gives it a payout ratio of 48%.
The stock isn’t really cheap today, trading at 18.5x 2023’s expected earnings. But this is a stock that never really gets exceptionally cheap. It sold off to about 14x earnings in 2018’s bear market, and was pretty cheap during the two week COVID crash in early 2020. And that’s really it over the last handful of years. It has traded as high as 23x earnings in the latter part of 2020.
I think 18x earnings is a fair price for the company, and I also think earnings increase by 8-10% over time. Add in my 2.5% dividend today and all investors need is for the multiple to remain consistent and they get a double digit return.
TMX Group is also pretty cheap compared to its peers. Intercontinental Exchange — which owns the NYSE and Euronext exchanges — trades at more than 20x next year’s projected earnings. The NASDAQ trades at 22x forward earnings. And the London Stock Exchange — which may be the best comparable because it also has large numbers of mining stocks listed — also trades at 22x forward earnings.
Another way to look at it is like this. What’s a fair price for a company that:
Generates 90%+ gross margins and 50%+ operating margins
Operates an asset with a clear moat
Consistently grows both the top and bottom lines over time
Offers a solid yield with 6-10% long-term annual dividend growth
I’d say right around a market multiple is more than fair, and that’s where we’re at today.
Is the company overearning because the last couple years have been good for capital markets? Analysts don’t seem to think so. Even if it has been, I’m still bullish on the company over the long-term. A weak 2023 would likely yield a better entry point, but I wouldn’t let the fear of an upcoming recession take away from the long-term opportunity I see today. But at the same time, I would be very excited to get this name 20% lower.
One last thing. The company has proposed a 5-for-1 stock split, to be voted on at the annual meeting on May 2nd. Although they shouldn’t matter, there is evidence out there that says companies who split their stock do tend to outperform their peers — at least over the short-term. It’s not a key part to this thesis, but it should help.
The bottom line
TMX Group is an excellent company trading at what I view to be a very fair multiple. It also offers a safe dividend, nice growth potential, succulent margins, and smart diversification away from its core business. It’s not just a stock exchange anymore, and I like that strategy.
It’s not especially cheap today, but this is a stock that very rarely gets down to what I’d consider a dirt-cheap valuation. You can wait for it to get cheaper, or you can buy today and average down if there’s a big event that sends shares 20% lower.
This is the kind of asset you can tuck away and own for a very long time. I’m happy I bought it and will be the first to buy more each time the stock falls 20%.
Disclosure: author owns shares of TMX Group