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Archipelago's Rich Sea of Possibilities

By Amy Tsao In August, Archipelago Holdings (AX), which operates an electronic communications network (ECN) and stock exchange, raised about $126 million in its initial public offering. It was a modest success, considering that in the days leading up to the Aug. 12 float, the offering price fell to $11.50 a share, down from $15.25. Since then it has settled in at around $14.

Many investors figure Archipelago's backers, which include Wall Street heavy hitters Goldman Sachs (GS), Morgan Stanley (MWD), and Fidelity Investments, wouldn't be investing unless its future is bright. That's simple logic, but it easily could turn out to be right on the money.

POSITIONED FOR GROWTH. Archipelago is positioned to take advantage of a major shift in the way Wall Street does business. ECNs, computerized systems that match sellers and buyers, have taken significant market share from the middlemen, known to Nasdaq's traders as "market makers" and "specialists" on the New York Stock Exchange (NYSE).

Electronic trading has taken over in Europe. But in the U.S., the main exchanges mostly still use middlemen. By eliminating those go-betweens, ECNs like Archipelago make trading both cheaper and faster. In the first half of 2004, Archipelago handled 25.6% of the total volume of Nasdaq-listed shares.

Growth has been phenomenal since its inception in 1997. In 1998, trading volume on Archipelago's ECN totaled 10 million shares daily. This year, the figure stands at some 575 million shares. Its fixed costs are relatively stable, so earnings should rise as long as it can gain more market share. In 2003, it reported total revenues of $458.5 million and net earnings of $1.1 million. On average, analysts expect sales in 2004 will rise by 18%, to $540 million, while costs won't rise nearly as much.

OWN RULES. Now Archipelago is on its next leg of growth: In 2001, it became the first ECN to get clearance from U.S. regulators to be its own stock exchange. Its ArcaEx exchange doesn't have a trading floor, but like other exchanges, it gets to set its own rules. As an exchange, rather than simply an electronic middleman, Archipelago figures it will have more say over how it does business, differentiating itself from other trading platforms. It can "determine its own fate," says Jim Marks, president of Marks Baughn & Co., an investment bank specializing in financial technology.

Given Archipelago's seeming potential, its shares appear relatively cheap.t $14, it trades at 13 times analysts' average 2005 earnings-per-share expectations of $1.06. By contrast, competitor Instinet (INGP) trades at $5 per share, or 21 times the 2005 consensus EPS of $0.23. Of the five analysts covering Archipelago, all are bullish and two rate it buy. In the long term, Archipelago says it can deliver 15% annual earnings growth.

Kevin O'Hara, chief administrative officer and general counsel at Archipelago, figures the company has much more room to grow since the shift to electronic trading is still in its early stages. And regulatory changes could give Archipelago a further boost. The Securities & Exchange Commission is currently debating measures that have the potential to increase electronic trading of stocks listed on the NYSE. "There's a hell of a lot" of growth potential for Archipelago, O'Hara says. In the first half of 2004, the company handled just 1.57% of all the volume traded in NYSE-listed stocks.

THE PATIENCE FACTOR. The biggest risk to Archipelago's plans is fierce competitive pressure. For two years, after a wave of mergers, the major players have been locked in a price war that has yet to ease. The Nasdaq recently acquired an ECN of its own, and this, too, is expected to gain market share.

So far at least, the fees Archipelago collects from exchange clients aren't providing much of a cushion. Some 94% of the $458.5 million in 2003's total revenues came from trading.

Archipelago has done "an outstanding job," says Rich Repetto, analyst at investment bank Sandler O'Neill, who cautions that, "the things they're talking about now -- getting revenue from listings and gaining more market share of trades on Nasdaq and NYSE stocks -- will take some time." (Repetto doesn't own the stock, but his firm received investment-banking fees from the IPO.)

MERGER CANDIDATE? Nonetheless, like other analysts, Repetto is bullish on Archipelago's long-term prospects. He figures the electronic trading sector is in for further consolidation and believes Archipelago could end up merging with Instinet, which bought Island ECN two years ago. Over time, mergers, though they come with risks, should make the resulting companies more profitable.

Given the potential for further change in trading technology and regulation, Archipelago's exact future is hard to predict. But it seems clear the market's ongoing demand for lower costs, more transparency, and greater efficiency puts it in one of Wall Street's sweet spots -- one way or another. Tsao covers the markets for BusinessWeek Online and writes for the Street Wise column

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