We mentioned in a recent article that NASDAQ OMX (NASDAQ:NDAQ) intends to acquire electronic bond trading platform eSpeed from BGC Partners Inc. for around $1.2 billion. We also stated that the company may have to take on a significant amount of new debt to fund this acquisition and that the elevated debt levels could trigger credit rating downgrades from S&P and Moody’s.
However, we maintain that eSpeed is likely be a good buy for the company at its current valuation and would add a net positive value to NASDAQ’s stock even if it grows annually by just 1-2% over the long term. In this article we look deeper into eSpeed’s current valuation that justify our expectations.
eSpeed Would Add Net Positive Value To NASDAQ
NASDAQ is paying $1.2 billion for the U.S. treasury trading platform and the acquisition would make sense if the present value of annual free cash flows generated by eSpeed exceeds the amount paid for it. Our estimates suggest that the platform will have to register revenue growth rates only in excess of 1.2% over the long term to justify this valuation. Here is how we arrived at this conclusion.
eSpeed forms a part of BGC Partners’ financial services division and is used for electronically trading interest rate, forex and credit products. NASDAQ is buying the “rate” products part of this platform, which primarily consists of U.S. Treasuries (actually “rate” products are defined as U.S. Treasuries, Canadian Sovereigns, European Government Bonds, Repos, Interest Rate Swaps, and Futures).
The trading of rate products on eSpeed generated about $532.4 million in revenues in 2012, which is around 43% of revenues generated by BGC’s financial services division. We allocated the total expenses (excluding interest expense) of around $1 billion of this division to “rate” products in the same proportion and arrived at EBIT of around $100 million for this niche. 
Using EBIT as a proxy for cash flows and using a discount rate of 9.7% for Nasdaq, we calculated the minimum terminal annual growth rate at which the business could be valued at $1.2 billion. Our calculations suggest that the long-term minimum growth rate needed to arrive at that valuation is just 1.2%.
Growth Could Be Faster If The Fed Ends Quantitative Easing
While 1.2% seems like a low hurdle rate, growth is likely to pick up after the Fed stops its bond buying program. As of January 25, 2013, the U.S. Fed held nearly $2.4 trillion worth of U.S. Treasury and Federal Agency securities, and it plans to buy additional securities worth $85 billion every month until the unemployment rate in the U.S. reduces significantly.  Once these securities are acquired by the Fed, they are not traded any further and because of that volumes for the entire U.S treasury segment are suppressed to an extent.
Due to this reason, eSpeed’s revenues have been hurt for the past several quarters. The number of transactions of interest rate securities, which includes U.S. Treasuries, on eSpeed declined to 3.2 million in Q4 2012 from 4.9 million in the year-ago quarter, a decline of 35% y-o-y.
We believe that NASDAQ is betting on an eventual improvement in U.S. Treasury volumes and expects that the acquisition could bring huge benefits to the company once this happens.
Where We Could Be Wrong
In the above analysis, we have assumed that NASDAQ’s discount rate will remain the same even after acquiring eSpeed. However, as mentioned in a previous article, there is a possibility that the company may have to take on significant amount of debt to fund the acquisition. This may lead to a downgrade in the firm’s credit rating.
If that happens, NASDAQ’s discount rate is likely to increase significantly and the long-term growth rate required to justify eSpeed’s $1.2 billion valuation will inch upwards. In a worst case scenario, if we increase NASDAQ’s discount rate to 15%, we expect the terminal growth rate required to justify eSpeed’s valuation to be around 6%, which is still not too high.
Our conclusion is that this acquisition will be contribute to Nasdaq’s value over time based on its expected growth rate and contribute to its rates trading capabilities.Notes: