We estimate the combined entity is trading on >30% discount to fair value, given uncertainty over the transaction. Our deep dive analysis of rulings on recent deals suggests hurdles are not insurmountable and highlights three areas that could ease concerns.
* Current valuations suggest >30% discount to fair value for LSE-DB1.
Given political and regulatory uncertainties, plus the likely EU move to a phase 2 investigation, the shares are pricing in substantial risk to the proposed merger. Even on conservative assumptions (no revenue growth, no change in organisational or capital structure and management cost save targets only), the combined entity is trading on an implied ~15x year 1 (FY17) earnings, vs. larger and less diversified global peers on ~20x. We are EW on both names
given the binary nature and lack of visibility on approval, but the risk-reward of the combined entity is potentially attractive.
* Analysis of recent deals suggests regulatory hurdles could be surmountable.
Leaving aside political risks, an assessment by revenue line item highlights listed derivatives trading and post trade clearing (OTC & listed) plus CSD services as areas where competition could be perceived as restricted
by the merger. We analyse UK and EU documents related to recent transactions (DB1-NYSE, LSE-LCH and ICE-NYSE) and see three areas that could ease regulatory concerns on the deal: (1) the EU commission takes into account upcoming regulation and its potential impact, which on balance is likely to drive more competition; (2) open access provisions could alleviate what the EU commission previously highlighted as barriers to entry in derivatives and; (3) the risks around monopoly behaviour in OTC clearing could be overstated, with the OFT suggesting LCH would be unable to implement discriminatory price rises. Scope for asset disposables could also
address regulatory concerns.
* We resume coverage on LSE and DB1 at Equal-weight.
The proposed merger is likely to be the primary driver of both share prices in the next 6-12 months, and visibility is limited. Looking at the stocks individually, we see potential overhangs if the deal does not go ahead pending clarity on management strategy, particularly at LSE.
* On fundamentals, LSE looks relatively better placed vs. peers
given (i) structural growth (e.g. post trade and information services); (ii) our view that it can over-deliver on cost saves: (iii) M&A and balance sheet optionality and; (iv) better relative positioning for regulatory change. Our FY16-18 earnings are slightly ahead of consensus. For DB1, the longer-term fundamentals are more challenged, we think, despite the current cyclical support. Our estimates are slightly below consensus, which already bake in the upper end of company targets. Our top picks are Tullett Prebon and Euronext, where we see scope for positive earnings revisions from management action to drive shareholder value.