Deutsche Boerse, A Merger That Need Not Happen

Deutsche BoerseDeutsche Boerse

Since the DB /LSE merger was announced (a year ago officially), it has been more beneficial to LSE shareholders than to DB’s, with a valuation gap (29x for LSE vs. 18x for DB) that has never closed. Respective shares have continued to trade in an uncorrelated way suggesting that not only the deal is not consummated but that the GBP/Brexit tango cannot be ignored. For Carax- Alphavalue “that LSE shareholders buy an insurance policy  is no longer a question since last June’s Brexit vote”. “Less clear is why DB shareholders would not have been better off going for a simple takeover of an eventually weakened by Brexit LSE.” One reason may have been to prevent ICE from swooping in and using LSE as its European springboard, thereby challenging DB’s strong position in derivative markets.
The main points of contention to finalise this merger are at an EU Commission level about the dominant clearing businesses of both firms on interest rate derivatives. A last minute decision to sell the French clearing business (LCH SA, sold to Euronext that enjoys the ride) has gone in the right direction but may not be enough.

It does not make sense but…
It is worth reminding that from a competition authorities’ standpoint this merger does not make sense as it bunches together two giants that dominate the derivative business (listed for LSE and cleared via LCH Clearnet and OTC for DB via Eurex) via a silo approach (i.e. with little by way of pricing transparency). The claimed merits of joining businesses for their professional clients (even more “offsetting” of derivative positions) are unlikely to feed through to their clients. Both firms also dominate the index management business through consolidation of this industry (Russell bought by LSE, Stoxx by DB) and turning it into an oligopoly. Index matters as the financial planet goes ever more global and ETF. Carax- Alphavalue’s analysts say:

The other reason why it does not make sense is that the junior partner (LSE) takes over the governance leadership with headquarters in London when the ECB is bent on bringing back to Frankfurt the clearing of euro rate derivatives after Brexit. That the boss of DB, Mr Kengeter, shall take over is both odd and unconvincing.

Governance issues have been raised of late as far as Mr Kengeter is concerned. He has since been fully backed by DB’s supervisory board. As Mr Kengeter is still new to the firm (if not to the financial industry), this governance issue is contributing to the general feeling (with Continental eyes) that this deal is weird.
The last comment os experts before moving on to earnings and valuation is that the Brexit discussions are now expected to be painful ones so that the issue of euro clearing in London will become a political hammer.

We would expect the ECB to think intensely about its EZB acronym and make it clear that this is it: end of story. In which case, the merger would look silly from a German shareholders standpoint. The mooted date for a final clearance by Brussels is April. Assuming that Article 50 is signed in March, both managements must really be walking on a tight rope.

FY2016 is due on 16/02. Q3 earnings lacked spark depending on what degree of conservatism inhabit shareholders. As they wrote on 28 November:

“The net profit attributable to shareholders declined by 9% to €151m for Q3 16 compared to Q3 15 regarding the Q3 16 report. The Q3 16 figures release, however, shows a net profit attributable to shareholders which increased by 9% to €170m for Q3 16 compared to Q3 15. This makes a difference and does not say much for the reporting quality of Deutsche Boerse in our view”.

Discontinued operations had a cost but this is not part of the communication exercise. DB is no worse than the majority of corporates in partial reporting but it is an irritant. The underlying story is one of no growth of the top line but cost contraction (-3%) which led to a 9% increase in profits (before discontinued). Being number one and seeing no top-line growth even though the strategic steps have been addressed through acquisitions certainly point toward a difficult business.

Earnings definition with a purpose?

The house valuation may be too cautious but the only upside is on a P/E and yield basis which reflects the high valuations of LSE. This is a circular support. Should DB stay a bachelor, analysts are not sure that its valuation is not already full.