Marcial: Taking Stock of Nasdaq OMX

The electronic exchange is luring some investors as more profitable trading trends and consolidation help boost its earnings

In these times of continued market volatility, one stock that some asset managers are snapping up is Nasdaq OMX Group (NDAQ). Yes, the shares of Nasdaq, the largest electronic equity market in the U.S. in terms of trading volume and number of companies listed on its exchange.

What's behind the stock's appeal? It's a defensive and aggressive investment play on the market because the company continues to be profitable, even during economic downturns. At the same time, it's a bold bet on the stock market's trading volume and activity.

Nasdaq has grown mainly through acquisitions. In February 2008, Nasdaq completed its merger with the Nordic stock exchange OMX, creating the world's largest exchange company. Part of the deal was taking a 33% stake in DFX, Dubai's international financial exchange. That agreement also allows Borse Dubai to buy a 19.9% stake in Nasdaq OMX. In July 2008, Nasdaq OMX purchased the Philadelphia Stock Exchange for $652 million. Nasdaq also acquired the Boston Stock Exchange in August 2008.

"Nasdaq OMX has been profitable since it went public in 2005, through economic ups and downs, with its earnings and revenues rising steadily," says Thomas Nyheim, vice-president and portfolio manager at Christiana Bank & Trust in Delaware, which has some $1.7 billion under management. Earnings have grown at a rate of 8% to 10% annually, he notes. Nasdaq has attracted some of the biggest technology companies to its market, including Microsoft (MSFT), Intel (INTC), Cisco (CSCO), and Oracle (ORCL). In that sense, he says, Nasdaq OMX's stock is regarded as a play on technology shares.

Extreme Volatility Can Hurt

True, Nasdaq OMX's stock tends to soften when the market is trading lower, when fewer traders and investors commit money to stocks or stock options. But even when the market is down, trading activity could also surge, which benefits Nasdaq's revenues and earnings. But almost surely, when the market rallies and the bulls take command, Nasdaq's stock advances as volume usually picks up.

The market meltdown that started last September was significantly different, however, when shares of stock exchanges, including Nasdaq OMX, took an unusual beating. "Volatility over a cycle is good for the exchanges' business, but extreme volatility as we saw in 2008 and 2009 isn't good, as volume gets concentrated among high-frequency trading that generates lower fees," explains Niamh Alexander, an analyst at investment firm Keefe, Bruyette & Woods (KBW), who rates Nasdaq's stock outperform. During such extreme volatile trading, customers who trade less frequently but pay higher fees tend to pull back from the market, says Alexander.

Management has diversified away from being primarily a U.S. equities-driven company. The company also will derive revenues from international equities trading, derivatives, technology outsourcing, and providing market data services, Alexander says. "Nasdaq OMX's management has a strong track record in doing deals successfully," the analyst says. She sees potential upside from the company's derivatives business and, for the long term, its international equities franchise.

Nasdaq OMX, however, isn't just a market for trading stocks and other securities. It is also a leading technology company in the financial-services industry. It provides advanced technology to other exchanges worldwide, as well as various equity and options trading services and securities listing.

Next Growth Area: Europe

Alexander expects Nasdaq OMX to earn $2.16 a share in 2009 and $2.61 in 2010, up from 2008's $1.58. Alexander's 12-month price target for the stock is 31, up from 20.34 currently. The company has been driving down costs to offset any decline in trading volume in 2009.

The market's changing structure in Europe, she says, will be an advantage for Nasdaq OMX, with its various services and products, as well as its skills in acquiring other assets. Europe will be Nasdaq OMX's next growth area, she believes. Consolidation among foreign exchanges is an opportunity for the company.

Although Nasdaq OMX is at the center of trading activity, its stock hasn't exactly been a household name. For one, Wall Street analysts don't go crazy over it. Sixteen analysts follow the stock and only eight recommend it as a buy, while seven rate it a hold or neutral. One rates it a sell. Big institutional investors have large stakes in Nasdaq's stock, but it isn't widely held among individual investors.

As Nasdaq OMX's footprint in the global markets grows, however, its image as an efficient securities market in the U.S. will become enhanced—and U.S. and foreign investors are likely to pay more attention to the stock.

Before it's here, it's on the Bloomberg Terminal.