TMX Group has been in the news in the last few days. First NASDAQ, a US-based equity exchange, said it was looking north to Canada for expansion. And second, Aequitias Innovations, a Canadian competitor to the TMX Group filed a complaint against TMX to the Canadian Competition Bureau over data pricing.
The stock has been hit over the last few days as investors focus on the impact of this recent news. However TMX Group has larger issues according to our Model Price Theory (MPT) math. I wrote this blog back in June, 2013 saying at best the stock would go sideways for the foreseeable future and at worse investors would lose some of their capital over the long haul.
It may take time but the Model Price math always works in the end.
If you haven’t figured it out yet, I love stocks. Not only do I love stocks but I want to know what makes them tick. Why do stocks go up and down? Why “the market” gives stocks valuation and ultimately takes it away?
As I mentioned previously when I was first introduced to the initial mathematical concepts behind what I call Model Price some 20 years ago, I got it right away – especially the concept of Theoretical Earnings (TE). Simply stated the calculation of TE of any public company yields what one can call benchmark earnings or what the company should be earning, again in theory, given the capital structure of the company and the capital employed in the business.
Once TE is calculated, you can compare the result to the actual earnings (AE) of the company. If AE is greater – which it usually is – the market gives additional valuation in the public financial markets for this differential between TE and AE. If a company is dynamically increasing its AE with TE staying the same or marginally increasing over time, equity markets usually signal its approval of this expanding ratio by increasing the valuation of the company. The antithesis is also true if dynamically TE and AE as a ratio is contacting, the equity market will take away valuation.
This should make sense to a lot of people. In essence we are comparing a public company to itself in terms of its own benchmark earnings or Theoretical Earnings. I like to think of individual companies as unique as fingerprints, each being individually different even though they may compete in the same industry. CEO’s have a large influence over their own TE calculation in the way they manage their business and can have a direct impact on their company’s valuation, again this should make sense.
If you think my line of logic is sensible – on the concept of TE – and wanted to seek out more information on the topic you will be disappointed. Unfortunately this financial concept (TE) is NOT taught in any business class, MBA or CFA program. So by reading this blog you‘re ahead of the other financial professionals in terms of equity analysis. TE analysis is embedded in our calculation of Model Price in case you were wondering.
We – at Acker Finley, including myself, – are constantly scanning our database of some 2,000 companies looking for any aberrations from past histories in terms of our computations on theoretical earnings and other model price concepts. This screening process is what I consider fun. It’s about being curious. It’s about asking the question “why” and not stopping until I get an answer. It’s about finding potential catalysts that can have a large price impact on an equity security sometime in the future.
TMX Group (X)
While scanning the database this week TMX Group (X) jumped out at me. Actually I was scanning the 52-week low list and X was on the list. I thought this was odd so as usual I call up the model price chart on TMX Group and this is what I see.
TMX Group (X) with weekly price bars, EBV Lines (colored lines) and model price (dashed line)
For those interested, a daily updated chart of X subsequent to this post will be maintained on Facebook, here.
This model price chart looked weird to me. TMX was a quality company since its IPO in early 2000: has anything changed? Also notice where the stock is trading – just over EBV-2. TMX is a profitable company with good earnings, so why is the company only trading at EBV-2? Interestingly our model price calculation seems to support the current market price of the company.
So I start to do some digging. And wouldn’t you know, TMX Group is NOT the TMX Group!
The original TMX group was purchased by a consortium of banks and pension funds commonly known as the Maple Group back in July of 2012. So the old TMX Group that had a good history of earnings and dividend gains no longer exists. Once the Maple Group purchased the company – old TMX Group – along with Alpha Trading Systems Limited Partnership (Alpha) and The Canadian Depository for Securities Limited (CDS) it renamed itself TMX Group.
Are you with me so far?
So, in essence this is a new company, with new financial statements. The model price chart illustrated above is correct (prospectively) but any financial history, including the history of our long-term model price chart is inaccurate. Keeping this comparable data may be informative from a historical perspective so I will keep the data and chart as is, but meaningless in terms of a financial data continuity and history.
What is the “Theoretical Earnings” of the new TMX Group (X)?
Here is our calculation of the TE of the new X with the past history of the old TMX Group.
Again, you are looking at two separate companies here. The history of our model price numbers no longer exists as stated on this chart. But it’s instructive and teachable analysis so I’m keeping it the way it is.
When our computers calculated a TE of $9.69, I didn’t believe it. This is massive. Remember this means this company, the new TMX Group, theoretically should be earning at least this amount in order to have any market valuation at all. I quickly looked at published mean earnings estimates for the company and discovered estimates $3.16 for 2013 and $4.00 for 2014. This is quite a shock. So like a good accountant I start digging through the financial statements, double checking the numbers – and they were correct!
This is way TMX Group is hitting new lows. This new company can’t earn their “Theoretical Earnings” the way the new owners constructed their balance sheet.
I could go into the mathematical minutia of why the TE is so large, but it would make this blog post too long and complicated. In a nutshell the primary cause for this substantial ‘TE’ number was the acquisition of CDS or The Canadian Depository for Securities Limited for a paltry $167.5 million. This was a terrible mistake, in my opinion.
Maple Group’s acquisition of CDS moved CDS’s balance sheet from private quasigovernmental ownership to public ownership. Unfortunately CDS’s balance sheet is too large relative to the earnings the public company actually receives and will ultimately crush the valuation of the public entity. In order to restore any sense of valuation to the new TMX Group this CDS subsidiary must be placed back in governmental or regulator hands where it previously existed. In other words this organization, CDS, cannot exist in the public marketplace for valuation purposes however performs a critical market function of clearing financial transactions in the Canadian financial marketplace.
As my title suggests TMX Group is a “Dead Stock Walking”. This company will never have earnings come anywhere close to its calculated “Theoretical Earnings” number. The best shareholders can hope for is lackluster to sideways action on the stock price. The worst is very dark indeed. If the stock does suffer, which I think it does, TMX Group will have to undergo a major corporate restructuring which may yield interesting profit potential for sharp-penciled investors down the road.
The other question I have is the confusion over the name of the company. I am in the industry I didn’t know the material changes of the transactions involving Maple Group and the old TMX Group resulting in the new company called the TMX Group. Without considerable digging and if I didn’t know any better I just thought TMX Group was the…. TMX Group!
I do feel sorry for the current and future high yield dividend investors making an investment in this company. As I said previously the old TMX Group was a good equity performer with a solid dividend yield. On the surface the new TMX Group appears to be the same company. This has disaster written all over it for investors looking for a quality company with a safe and growing yield.
P.S. During the week a new consortium of financial players in the Canadian market place announced the formation of Aequitias Innovations to compete directly with TMX Group. This is not good news for TMX Group that may face earnings pressure down the road with a sky high ‘TE” placing further potential pressure on the future stock price.
P.P.S. One of the investors in the Maple Group is the Canada Pension Plan Investment Board. Great to see my (and your) retirement dollars potentially going up in smoke on this one!
P.P.P.S. I love counter-intuitive situations in business and flawed common sense thinking. Everything Maple Group did in this transaction seemed perfectly reasonable. I’m sure the well-intentioned Board of Maple Group with the best minds in Canadian finance congratulated themselves on a job well done. Also, I would bet money that there were more MBA’s and CFA’s on this file then any other business transaction performed in Canada in the last decade! Will be interesting when this situation turns south who is left holding “the bag”. (Hint…. It’s usually the CEO!)
P.P.P.P.S. The last company I saw in the past that had this relationship, too high of a ‘TE’ relative to ‘AE’ was AOL-Time Warner back in 2000. Yes, you are correct, that didn’t end well either!