NYSE: Hooray for Market Volatility

The huge operator of financial exchanges is benefiting from the market's recent wild swings

In the last few months market volatility has made the world's bourses the hot place to be. The wild swings in the market may have hurt investors large and small, but exchanges are raking in record profits by handling all those buy and sell orders in stocks, derivatives and other trading products.

A prime example is NYSE Euronext (NYX). Created by the merger of the holding company for the New York Stock Exchange and the giant European exchange Euronext, it is the world's leading equity exchange, listing companies with a market value of $29 trillion, more than the next four exchanges combined.

In an earnings report Nov. 2, NYSE reported earnings of 97 cents per share, vs. 43 cents a year ago. It nearly doubled revenue in a year, to $1.2 billion last quarter.

For NYSE, "it's been an incredible year in so many respects," says Brad Bailey, an analyst at the Aite Group.

A few years ago, the New York Stock Exchange was a private organization, owned by its members. If you wanted to buy a stock listed on the exchange, you needed to go through a human trader on its busy trading floor on Wall Street.

Then, NYSE became a public company. It embraced computerized trading by buying up an electronic exchange. It looked for growth abroad by merging with Euronext, and looked for new products to trade beyond stocks, including derivatives and electronically traded funds (ETFs).

NYSE's third quarter profit reports show some of its bets are paying off. Revenue from derivatives, which provide a higher profit margin than stock trading, were up 75% in a year. Bank of America (BAC) analyst Christopher Allen called that number "stellar."

The expansion across the Atlantic is also boosting the bottom line. "The European operation is increasingly apparent as the strongest growth engine for the business," wrote Niamh Alexander of Keefe, Bruyette & Woods (KBW).

In one sense, NYSE was forced to expand aggressively because it's getting squeezed on its historic strength: U.S. stocks. The rise of electronic trading has made the Wall Street trading floor a quieter, lonelier place, and new regulations make it easier for new, cheap and fast electronic exchanges to challenge NYSE.

The profit report, though strong, had a mixed effect on NYSE's stock. On Nov. 2, shares spent most of the morning in negative territory before recovering slightly in the afternoon. As Allen wrote in the morning, "Expectations were fairly high ... and given the recent run the stock has had, we would not be surprised to see NYX under pressure today."

Indeed, the stock is up 17% in the last three months, and trading at a price-to-earnings ratio of about 49, one of the highest P-E ratios on the S&P500 index.

One of the biggest questions for NYSE is how well it will be able to integrate its new acquisitions, especially Euronext.

Exchanges rely on very expensive computer systems that must carry billions of pieces of data in milliseconds without fail. So, one big argument for mergers is the big cost savings from sharing systems. NYSE and Euronext promised $275 million in savings and $100 million in extra revenue from their merger. Those didn't really show up in last quarter, analysts say, which may worry some investors.

However, chief financial officer Nelson Chai tried to reassure them. "We continue to make solid progress and remain confident in our ability to deliver," he said, adding that the most of the savings would come next year, after a new, combined trading platform is completed.

NYSE shows no sign of slowing down its expansion efforts. It's speeding up trading systems, investing in an exchange in Brazil, forming partnerships on new trading platforms in the U.S. and Europe, and helping to launch a carbon trading platform. It admits to considering more acquisitions, including perhaps a U.S. futures exchange.

Threats to NYSE include possible problems with these acquisitions and partnerships, increased competition and a slowdown in the world's unprecedented growth in trading volume.

"Everywhere you look on the planet, there is a lot going on in the trading world," Bailey says.

An investment in NYSE Euronext is a bet that exchanges continue to see faster -- and more frenzied -- trading activity.

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