Competing for Customers and Capital

Play It Again Sam

In the week since "Exchange Wars" [ICE vs. CME] was published last Sunday, visits to this blog spiked by nearly 500. Given the somewhat esoteric and totally unconventional analysis that appears on my blog, this represented a huge boost in readership. What was responsible? My conclusions were a bit provocative.

First, the analysis of each company plus the object of their affections -- the Chicago Board of Trade (BOT) -- showed that it was in the interest of the Chicago Mercantile Exchange (CME) to pass on this one. I argued they already had 53.8% of the combined revenues of the three companies and acquiring the BOT would give it 84.5% of the market. At that point my analysis said the CME would be over-invested and would, as a result, leave about $100 million in earnings on the table in the first year. This would hurt the merged company's market value.

Second, the analysis documented a good enterprise marketing fit between the IntercontentalExchange (ICE) and the CBOT: the combined companies would maximize earnings at a market share of 52%.

IT TAPPED INTO A CHORD
My post got quite a bit of play the first day from the New York Times DealBook and from SeekingAlpha.com on the second day. Together they generated 109 visitors.  One of these visitors probably sparked the critical reply from Jeff Carter, who I don't know, but who seems to have forgotten more about exchange markets than I'll ever know. My reply to his comments and his reply to mine, spell out all the issues I detail. Suffice it to say, that post tapped into a chord.

THREE DROP-DEAD ISSUES
Since my analysis was static (based on a single period), used "interest expense" as a proxy for the cost of goods sold, and was built on financial accounting data, I was not surprised to read that:

1) In a dynamic, growing environment like futures exchange markets, a single period analysis is incomplete, at best;

2) Reported interest expense is not the "cost of goods sold" in futures exchanges; and

3) Financial accounting numbers aren't real economic data and should not be used in M&A analysis. Instead you must use cash flow numbers.

As you can image these comments motivated me to look more closely into the issue and produce an updated analysis that addresses them. That's the purpose of this post.

FUTURES EXCHANGE REVENUE GROWTH
To create a multi-period analysis the Exchange Wars, I had to use nine quarters of data ending in March, 2007 since all three companies have been public only for that time. During that period the same-quarter, year-on growth rate averaged 38%. This supports Mr. Carter's assertion that a single period analysis is incomplete. Applying this growth rate to the historical data produces the following forecast of group revenues through the 2nd 2008. [click to enlarge charts]

ZERO COST OF GOODS SOLD
Whether or not the "cost of money" reflected in a firm's interest expenses is a reasonable proxy for the "cost of goods sold" in financial institutions is, I believe, debatable. What I was trying to capture is average variable cost of a "round turn" trade. But in this case it really doesn't matter because that cost is so small relative to enterprise marketing expenses it can be ignored. In fact, ICE reports its revenues are equal to its gross profits!

THE COMPETITION FOR CAPITAL IS REAL
Financial analyses by the M&A guys in their proxy documents for ICE and CME reportedly use ten year cash flow analysis of each company to support their merger cases. But, these cash flow projections are made for each company separately without incorporating the plans of the competitive bidder in the projections. In short, the case for ICE ignores the impact of CME its projections and visa versa. Though I have not seen these proxy documents, I expect the M&A guys include some vague language about "over reaching" on the one hand and "under estimating" on the other, to address the fundamental issues involving their competition for capital. This just won't do. The competition for capital is just as real as the competition for customers. M&A analysis should build the dynamic effects of competitive plans into all projections.

THE COMPETITION FOR CUSTOMERS IS REAL TOO
For all its virtues in financial analysis, there is one serious failing in cash flow analysis – you can't identify the flow of cash from its source. In other terms, there is no such thing as "activity based cash flow analysis."  Despite its limitations, the enterprise marketing expense that firms report in their income statements are as close as a mere mortal can get to building the competition for customers into M&A analyses.

CME's MAXIMUM EARNINGS MARKET SHARE
The results of a maximum earnings market share analysis of the CME over time do not change much from the single period analysis. This chart tells the story.

Actual share (white) has fallen ten share points from 59.3% in March, 2005 to 49.1% in March 2007. At the same time, maximum earnings market share fell from about 60 to 55 share points. Notice how close the CME came to maximum earnings market share in every period until June 2006. Then the gap widened significantly from 100 basis points in March 2006 to 620 basis points in March 2007. What's going on here? Over the nine quarters ICE's revenues increased 280%. This aggressive market expansion has increased the opportunity both for CME and BOT. ... all ships rise with the tide.

CME's MAXIMUM AND ACTUAL EARNINGS
The results are reflected in CME's maximum earnings after enterprise marketing expenses. They achieved almost the greatest relative earnings productivity possible -- the biggest difference between actual and maximum earnings was $8 million in December, 2006.

BOT'S ACTUAL AND MAXIMUM EARNINGS OVER TIME
Group revenues are forecast to increase from $729 to $1,008 million by June 2008. The CBOT's maximum earnings market share increases from 30.73% to 51.23% over the period. This drives its revenues up from $223.94 to $516.30 million.

Since its "cost of goods sold" is barely measurable, these revenues become its gross profits. In order achieve maximum earnings, CBOT's enterprise marketing expenses increase from $86.72 to $251.81 million. This drives EBITDA to increase over two fold, dropping enough earnings to the bottom line to increase EBITDA per share from $1.91 to over $5.01 by the 2nd quarter of 2008. Both EBITDA and enterprise marketing to revenues increase dramatically.

PLAY IT AGAIN SAM
How can the Chicago Board of Trade possibly achieve a market share of 51% in just five quarters? By merging with the IntercontinentalExchange. It this a good idea? Yes, from an enterprise marketing perspective.

THE SCALING FACTOR
But there's another serious concern raised in my discussions with Jeff Carter: can the ICE trading platform be expanded quickly and reliably enough to take on the additional volume of the CBOT? It's no small task. I calculate from CFTC reports that the CBOT had 513 million Open Interest contracts in 2006 on a wide range of commodities. Some of these are not traded on the NYBOT. That exchange had just 160 million Open Interest contracts in 2006. The scaling factor is over 3.5 times. Can ICE deliver on its promise?

~V

Exchange Wars

DUKING IT OUT
On June 14, 2007 the New York Times DealBook reported the latest development in the Exchange War between the "ICE" and the "CME" over a property they both want:

As two of the Chicago Board of Trade’s rivals continue duking it out over the exchange, its board of directors spoke up on Thursday: it favors the Chicago Mercantile Exchange.

But the IntercontinentalExchange Inc. (ICE) seems to want the Chicago Board of Trade (BOT) badly. Dow Jones MarketWatch reported late Tuesday June 12 that the company had enhanced its offer. It now represents a 10.2% premium over Chicago Mercantile Exchange (CME) bid. And

ICE also said it plans to file a preliminary proxy statement to oppose the proposed acquisition of CBOT Holdings by the Chicago Mercantile Exchange (CME) and solicit votes against the proposed CBOT/CME merger at the CBOT shareholders meeting scheduled for July 9.

Given the reported challenges faced by ICE in shifting CBOT's action to its New York Board of Trade platform, as well as the premium it has already offered to pay for the property, one wonders what's behind this ambitious strategy. CEO Jeffrey Sprecher says "It's a growth play." Is he right?

THE THREE PARTS OF A DOLLAR
To understand the motives behind an audacious strategic move like Mr. Sprecher's, it's useful to start with the enterprise marketing concept of "the three parts of a dollar." Why? Because it divides the sales dollar up into three mutually exclusive and exhaustive parts that define, with the use of financial accounting data, the company's underlying business model.

COST OF GOODS SOLD
The "cost of goods sold" at the Chicago Board of Trade in 2006 was 0.24%. Does this mean the company's gross margin is over 99%? Yes. Think of these three companies as retailers of risky financial products to highly select clients. Here's how the CBOT defined its business in its 2006 annual report:

CBOT Holdings was formed in April 2005 as a Delaware corporation for the purpose of becoming the holding company of the CBOT which was founded in 1848. Today, the CBOT is the world’s leading marketplace for trading agriculture, grains and U.S. Treasury futures as well as options on futures. In 2006, 13% of the global listed futures and options on futures contracts traded at the CBOT.

It's clear the company does not have a "cost of goods sold" like a product manufacturer or retailer. So what is cost of goods sold at such companies? Simple. The interest paid on borrowed money. The CME was the least efficient with an interest cost of goods sold equal to 8.45%. ICE was the most efficient with a cost of just 0.07%.

ENTERPRISE MARKETING EXPENSES
Calculating the enterprise marketing expenses of these three companies is a little more complicated. And you can't take the SG&A expenses reported in online services. Often the result make no sense. For example, Yahoo! Finance reported that the Chicago Mercantile Exchange had SG&A expenses of +$24.615 million in the 2nd quarter of 2006!

You have several options in assembling enterprise marketing expenses from the income statements of these exchange services. The least attractive option is to comb through each company's annual report and pick out all the line items that fit this definition:

Enterprise marketing expenses are the costs of everyone (and everything) that affects a company's performance in its competition for customers and capital.

If you're interested in the details of which expenses fit this definition see my audio slide show on "Enterprise Marketing Expenses." It runs about 12 minutes.

The most attractive option in my experience is to subscribe to EDGAR Online I*Metrix services:

I-Metrix is a suite of interactive data and analytical tools from EDGAR Online that provides quick and accurate, XBRL-tagged financial statement data via Microsoft Excel and an easy to use web interface or via a direct data feed.

Here's a list of all the line items in the income statements reported by I*Metrix that include at least a single entry for one (or more) of these three companies in their 2006 income statements:

Each of these enterprise marketing expenses influence the company's performance in competing for customers and capital. Here are the enterprise marketing expenses of each company.

There are two big advantages in using I*Metrix to assemble enterprise marketing expenses. First, the line items are standardized across all companies (whether or not they report the expense separately). Second, with a single mouse click you can drill down into the original SEC document to discover which items, if any, were combined.

COULD IT BE MARKET SHARE?
Revenues for the group of three firms totaled just over $2 billion at the end of 2006. The CBOT captured 30.7%, ICE got 15.5%, and CME led the group with 53.8%.

Could it be that ICE covets BOT because the combined firms would achieve maximum earnings market share and leapfrog the Merc?

I applied The Rule of Maximum Earnings (this audio slide show runs 12 minutes) to the data for the CBOT.

CBOT's actual operating income was $354 million on a market share of 30.7%. Maximum OIBD of $418 billion occurs at 45.5%. How could the Chichao Board of Trade grow that much additional share? If BOT were acquired by ICE their combined market share would be 46.2%! That's only 52 basis points from BOT's maximum earnings share.

WHY LEAVE $100 MILLION ON THE TABLE?
Okay, but what about the alternative? The Merc already owns 53.8% of this market. If it wins the exchange war, the company will own 84.5% of the market. This will maximize its earnings, right? Wrong. This chart shows what happens to market share and earnings if CME wins the bet for the CBOT.

If the Merc wins the bidding, combined earnings of the merged companies would be $968 million at a market share of 84.5% on sales revenues of $1,711 million (in red). While maximum earnings of the combined firms are $1,078 million at a 75% market share on revenues of $1,520 million (in green).

Even if the Merc bid doesn't run into anti-trust issues, the market eventually will drive it to downsize to a point closer to its maximum earnings market share. Why? Because the merged companies will leave over $100 million in earnings on the table.

A BIG ROLE FOR ENTERPRISE MARKETING
Where does traditional marketing fit in this seemingly complicated story? Look back at the list of line items from the income statements that contribute to enterprise marketing efforts. The first one is Marketing and Advertising expenses. Only the Chicago Mercantile Exchange reported any of these traditional expenses. And the total was just $16.74 million in 2006. In a strategic group with revenues of $2.0 billion. Traditional marketing's slice of this pie isn't even rounding error.

Does this mean traditional marketing has only a small role to play in financial institutions that serve a relatively small set of highly select customers? Yes, but enterprise marketing can step in and offer CEOs and CFO's unexpected insights into the challenges they face in the competition for customers and capital --- even in esoteric markets. In this case, it appears that the CBOT should think about switching its bet to the ICE before the window closes on July 9, 2007. What do you think?

~V

Do the Economics Make Sense?

Sorry to disagree with analysts at two of the biggest companies on the planet, but the economics make a lot of sense if you look at the long term impact of Mr. Murdoch's buyout of Dow Jones through the lens of the enterprise marketing framework.

BACKGROUND
In my post on "Dow Jones: Anomaly or Hidden Value? I placed the company in a strategic group with the New York Times (NYSE: NYT), Gannett Company Inc. (GCI), and the Tribune Company (TRB). The result of applying my Competitive Stock Valuation theory suggested that both the market and Mr. Murdoch undervalued Dow Jones. The present value of its stock four years out was $75 a share, or the company was worth a little over $6 billion. I discounted the forecast (nominal) value of its stock in 2010 (about $118) by 12.5% to adjust for my guess about the riskiness of Mr. Murdoch's acquisition.

THE HEAVYWEIGHTS: IT DIDN'T MAKE SENSE
At 9:00 this morning the following report appeared on the New York Times DealBook:

General Electric’s NBC unit and Microsoft explored making a joint bid for Dow Jones … But after the preliminary discussions and a more detailed analysis by NBC and Microsoft executives, they decided against going further. “Mainly, the economics just didn’t make sense,” a person close to NBC and Microsoft told The Times.

WHAT WOULD MURDOCH DO?
On June 6, 2007 Steve Stecklow and Martin Peers published a wide ranging interview of Mr. Murdoch's role as a proprietor and his plans for the Journal. This was one of the most revealing exchanges in that interview:

WSJ: So you would focus on generating more ad revenue?
Mr. Murdoch: … The Journal has had no money spent on marketing that I'm aware of for years. I imagine whatever we do would take the profit down in the short term… I mean of the Journal… It's got to have money put back into it, particularly on the digital side.

STRATEGIC ASSUMPTIONS
What if his bid for the company were successful? To find out I made these assumptions as inputs in my Competitive Stock Valuation model to forecast DJ's price in 2010:

(1) Mr. Murdoch's skill at running a paper combined with his marketing savvy would cause the CAGR in group revenues to jump from its historical 3.8% to 4.8%.
(2) he would stop in its tracks the steady 2.3% compound average annual decline in DJ's percent gross margin;
(3) his competitors would back-off the compound annual rate of growth in enterprise marketing (SG&A) expenses from 4.2% over the past decade to 1.8% in the ensuing four years;
(4) under Mr. Murdoch's leadership a revitalized Dow Jones would achieve maximum earnings market share;
(5) the number of shares outstanding would remain constant at 82.1 million.

THE ECONOMICS DON’T MAKE SENSE?
This table compares my 2010 Dow Jones forecast based on these assumptions with actual results in 2006. Group revenues increase from $18,625 to $22,467 million. DJ's share of group revenues increases from 9.6% to 22.4%, driving sales revenues up from $1,784 to $5,023 million by 2010. With profit margins held constant at 51% of sales, gross profits increase from $879 to $2,450 million in the forth year. With Mr. Murdoch pouring money into enterprise marketing, SG&A expenses nearly triple from $652 to $1,902 million.

The last three lines in this table are where it gets really interesting. Earnings (EBITDA) nearly double from $245 million to $548 million, driving EBITDA per share from $2.99 to $6.67, while the SG&A expense to revenue ratio increases only about 4%.

THE MOMENTUM EFFECT
How can Dow Jones become so radically transformed under Mr. Murdoch's leadership that it's 2010 stock price is $118? By becoming what Professor J. C. Larreche of the INSEAD Business School in Fontainebleau, France calls a "momentum-powered firm."

It all comes down to delivering more compelling values to its advertisers, its readers, employees, partners and shareholders -- and focusing on those that deliver the greatest equity to Dow Jones & Company. More on Professor Larreche's book on "The Momentum Effect" in later posts.

~V

Anomaly or Hidden Value?

WHY THE BANCROFTS WANT TO TALK
On May 31, 2007 the Dow Jones & Company (NYSE: DJ) said that a director who is a representative of the Bancroft family, Michael B. Elefante, had informed the Dow Jones Board of Directors that:

After a detailed review of the business of Dow Jones and the evolving competitive environment in which it operates, the Family has reached consensus that the mission of Dow Jones may be better accomplished in combination or collaboration with another organization, which may include News Corporation.

Friday the New York Times reported a noon meeting was scheduled for Monday June 4, 2007 between representatives of the Bancroft family and Rupert Murdoch's News Corporation. It is said that Mr. Murdoch will be there.

Mr. Elefante's reference to "the evolving competitive environment" motivated me to look at a group of four leading publishers through the lens of the Enterprise Marketing Framework. So I downloaded the 10-K filings of Dow Jones, Gannett Company Inc. (GCI), New York Times (NYT), and the Tribune Co (TRB) from 1997 through 2006. Fortunately, the fiscal year end for all four companies is December 31st, so all their annual reports were on file with the SEC.

If you want to know the nitty-gritty details behind this analysis, check out this audio slide show of my Competitive Stock Valuation theory. If you don't want to know these details, take my word for it. It's what you need to get a bead on "the evolving competitive environment" using company financial accounting data. Competitive stock valuation boils down to these two measures of company performance:

(1) risk-adjusted differences (RAD) between share of value and sales revenues and

(2) relative earnings productivity (REP).

RISK-ADJUSTED DIFFERENTIALS
RADs tell you how a company is performing in its competition for customers (in product markets) compared with its competition for capital (in equity markets). It’s a bit like the value/revenue ratio, with two important refinements: it's adjusted for risk (volatility) and takes competitive performance into account. RAD is a whole numbered index that runs from a minimum of -100 to a maximum of +100 points.

A negative RAD is bad news. It means your share of value is less than your share of sales. Or, put another way your company's share of churn is greater than its share of capitalization. And the greater this (negative) difference, the worse off is your company. Alternatively, and for opposite reasons, a positive RAD is good news. And the bigger the better.

In a study I did for the Marketing Science Institute of 38 member companies and 299 of their competitors over ten years I found the expected value of RAD was zero. Another of its useful properties is that the standard deviation of a company's RADs over time is exactly one. Which means any RAD smaller that -2.0 is really bad and any RAD greater than +2.0 is really good.

DJ's risk-adjusted differential was really bad. In 1997 its RAD was -3.0. But over the decade investors and management brought the company up to average (it was 0.0 in 2006).

RELATIVE EARNINGS PRODUCTIVITY
REP tells you how productively your company is using its resources to generate sales and earnings. I was inspired to create this metric by Al Rappaport's book Creating Shareholder Value. Here's what he said about the relationship between competitive advantage and shareholder value:

It is … productivity that the stock market reacts to when pricing a company’s shares.  Embedded in all shares is an implied long-term forecast about a company’s productivity – that is, its ability to create value in excess of the cost of producing it.  When the stock market prices a company’s shares according to a belief that the company will be able to create value over the long term, it is attributing [this belief] to the company’s long-term productivity or, equivalently, a sustainable competitive advantage.  In this way, productivity is the hinge on which both competitive advantage and shareholder value hang (Rappaport 1998, 69).

Relative earnings productivity is the percentage difference between a company's actual earnings and its maximum potential earnings. I purposely scaled this metric so the best REP is zero. That's when actual and maximum earnings are equal. When a company is losing money, relative earnings productivity can be a very large negative number. Think of it as a new measure of earnings quality that links competitive advantage to shareholder value. Which brings me back to "the evolving competitive environment."

TAKE THE MONEY AND RUN
This chart shows DJ's risk-adjusted differentials (RAD) on the horizontal axis, ranging from -3.0 to +10.0, plotted against its relative earnings productivity (REP) ranging from 0.0% to -41% over the ten years 1997 through 2006. In the upper left-hand corner of the graph DJ's 1997 RAD was -3.0; its REP was -11%. In 2000 DJ's REP deteriorated to -41%, but its RAD jumped to -0.5. The company's actual earnings were $606 million, while its maximum potential earnings were $1.0 billion.

One would think DJ's risk-adjusted differentials would have deteriorated further to, say -5.0, but they improved to -0.5! By 2006 DJ's relative earnings productivity remained low at -27% but RAD increased further still to 0. What does this mean? It may be a good time to take the money and run.

ANOMALY OR HIDDEN VALUE?
How can relative earnings productivity fall while risk-adjusted differentials increase? It comes down to these two possibilities: the DJ results are an anomaly or investors see serious hidden value in the company.

I opt for the hidden value theory. Dow Jones & Company with two of the most widely recognized brand names in the world – the Dow Jones Average and the Wall Street Journal – would be far more valuable under new leadership. Want some evidence of this? For one thing, based on Interbrand data, the Reuters Group ADR (NasdaqGS:RTRSY) brand was listed in Business Week's 100 Top Brands in 2006 with a value of $4.0 billion. Neither the Dow Jones Average nor the Wall Street Journal appeared on the top brands list! There's gotta be a lot of hidden value there. Want more proof? Rupert Murdoch has offered the family $5 billion for their company.

Is Mr. Murdoch the only one who believes there's hidden value in these two global brand names? No. Under the right leadership, four years out (with a discount rate of 12%) my analysis shows the present value of DJ is $75 a share or a little over $6 billion.

~V