Nasdaq (NDAQ) – Transforming Future Capital Markets

I first reviewed Nasdaq, Inc. (NDAQ) in this October 21, 2021 post at Financial Freedom Is A Journey. Based on my analysis, I decided not to initiate a position.

On June 12, 2023, NDAQ announced that it entered into a definitive agreement to acquire Adenza from Thoma Bravo for $10.5B in cash and shares of common stock; Adenza provides mission-critical risk management and regulatory software to the financial services industry. The rationale for the acquisition is to accelerate NDAQ’s strategic vision to become a leading technology provider to the global financial system.

Adenza benefits from the increasing regulatory reporting and risk management needs of major banks and brokerages. This trend is unlikely to diminish and thus expectations are for Adenza to continue to grow revenue in the double digits of which a significant percentage is recurring revenue.

In my June 13 post, I disclosed my decision to initiate a position with the purchase of 500 shares @ ~$51/share through a ‘Core’ account within the FFJ Portfolio on June 12.

I subsequently reviewed NDAQ in this July 20 post following the release of Q2 and YTD2023 results. In that post, I disclosed my decision to acquire another 100 shares @ $50.75 on July 19 through the same account.

My current exposure is 601 shares; automatic dividend reinvestment is how I obtained 7 additional shares.

Business Overview

Part 1 Item 1 – Business in NDAQ’s FY2022 Form 10-K provides an excellent overview of the company.

NDAQ has benefited from higher market volatility and increased retail interest in equity markets. The increased prevalence of $0 commission trading platforms should continue to provide a modest tailwind to trading volume. The equity exchange business, however, remains highly competitive. In 2020, for example, two new exchanges were launched (Members Exchange and the MIAX Pearl Equities Exchange). Furthermore, NDAQ continues to experience pushback from clients and regulators on the pricing of its market data products.

NDAQ identified these weaknesses when it conducted its strategic review a few years ago. Following its strategic review, it decided to transition away from its exchanges business to become a diversified software and technology platform company. As part of this reorientation, NDAQ is focusing its attention on the growth potential of its solutions businesses where it believes it can grow 7% – 10% organically over the next 3 -5 years while also benefitting from more reliable revenue generation (ie. recurring revenue in the form of subscription or licensing fees). Through a series of strategic acquisitions, Nasdaq is transforming future capital markets.

It is also pursuing opportunities with large total addressable markets, such as antifraud services and financial compliance.

When I wrote my October 21, 2021 post, NDAQ had completed the acquisition of Verafin for $2.75B in February 2021. NDAQ’s leverage had ballooned to 3.5X Gross Debt / Non-GAAP EBITDA; leverage rose to 3.3X following the 2017 Evestment acquisition.

While I was somewhat apprehensive about NDAQ’s leverage when I wrote my October 2021 post, it has demonstrated its ability to deleverage within a reasonable timeframe.

Adenza Acquisition

Rationale For Acquisition

NDAQ provided an Adenza-related presentation on June 12 when it announced its intent to acquire the company.

Expectations are for this transaction to close within 5 – 8 months, subject to regulatory approval and customary closing conditions.

At closing, NDAQ will issue the shares to Thoma Bravo thus resulting in Thoma Bravo owning ~14.9% of the outstanding NDAQ shares.

On July 19, NDAQ provided additional information as it relates to the impending acquisition.

The financial industry participants face a steady stream of new regulations and reforms which present reputational and financial risk. With the addition of Adenza, NDAQ positions itself to be a key partner in helping participants manage those risks.

NDAQ will enable its clients to meet regulatory mandates to:

• reduce financial crime;
• manage liquidity risk; and
• provide resilient capital markets infrastructure

while reporting on their compliance to over 100 regulators and agencies globally. In essence, the addition of Adenza’s capabilities to the NDAQ platform will increase the serviceable addressable market by ~40%.

In the first half of 2023, Adenza maintained strong Annualized Recurring Revenue (‘ARR’) growth in the high teens as compared to the first half of FY2022. This growth was underpinned by continued strength in gross and net revenue retention at 98% and 115%, respectively.

The fundamental drivers of growth in Adenza’s business come from new client sales, cross-sells, and up-sells to existing clients. Consistent with its strong performance in signing new clients over the last two years, both Calypso and AxiomSL continued to demonstrate strong growth which validates NDAQ’s acquisition thesis.

During 2021 – 2022:

• Calypso added 37 new logos, with upsells to 160 clients
• AxiomSL added 27 logos, with upsells to 117 clients

During the first half of FY2023:

• Calypso signed 7 new clients and completed upsells to 40 existing clients
• AxiomSL added 7 new logos, 2 of which were cross-sold to Calypso clients, with upsells to 25 existing clients

NOTE: Historically, Adenza sales cycles seasonally skew towards the second half of the year, accounting for ~60% of full-year bookings.

Acquisition Financing

Following the closing of the Adenza acquisition, management anticipates NDAQ’s leverage will increase to ~4.7X Gross Debt / Non-GAAP EBITDA. Although this level is high, NDAQ has demonstrated its ability to reduce leverage following prior acquisitions; management is committed to reducing leverage to 4.0X and 3.3X in 18 and 36 months, respectively.

Nasdaq will issue 85.6 million common shares. The value of the common stock is to be based on the volume-weighted average price per share over 15 consecutive trading days before signing the agreement.

It has also issued $4.25B in US dollar-denominated debt across 2, 5, 10, 30, and 40-year terms and EUR 0.75B euro-denominated 8-year bonds. Furthermore, to aid it in managing its deleveraging plan, funding of the remainder of the cash component of the transaction will be with commercial paper and the issuance of a $0.6B term loan just before closing; the estimation is a weighted average cost of debt just under 5.5%.

To minimize the carrying cost of the debt before closing, Nasdaq is investing the proceeds of the bond issuances in highly liquid and low-risk investments. Expectations are that the net carrying costs will be less than 50 bps at current market rates; this cost will be excluded from NDAQ’s non-GAAP results.

The following is a high-level overview of NDAQ’s debt and includes the recently issued debt for the Adenza acquisition

Crypto Custody Service

In September 2022, NDAQ announced that it was putting together the infrastructure and regulatory approval needed for a crypto custody service. It had applied to the New York Department of Financial Services (NYDFS) for a limited-purpose trust company which would oversee the custody business.

However, NDAQ has recently announced that due to the shifting business and regulatory environment in the US, a decision has been made to halt the launch of the US digital asset custodian business, and all related efforts to pursue a relevant license.

What prompted this pullback is a widening crackdown by regulators that aims to isolate crypto’s risks from the US financial system. Banks have been warned about their exposure to crypto businesses, and the US Securities and Exchange Commission (SEC) has filed a series of lawsuits against some of the industry’s biggest firms, including Binance and Coinbase Global Inc.

The decision to halt the US custody business will have a modest financial impact by contributing to a decrease in NDAQ’s FY2023 expense growth guidance (see FY2023 Guidance section below).

Despite this recent decision, NDAQ will continue to build and deliver technology capabilities that position it as a leading digital asset software solutions provider to the broader global industry. This includes advancing the custody solution as a technology platform to serve the broader global digital assets marketplace.

CEO and NEO Compensation

I think CEOs and NEOs are often obscenely compensated relative to all other employees. However, I own so few shares in the companies in which I have exposure that my shareholder votes are irrelevant. I must resign myself to being unable to effect any changes to the compensation structure of senior executives, and therefore, must determine if the compensation structures of CEOs and NEOs align with my long-term interests.

If the long-term incentive component makes up a large percentage of the CEO’s and NEOs’ compensation structures, I envision they will make decisions that align with my interests.

Based on my review of the compensation structures of NDAQ’s senior executives, it appears they are incentivized to position NDAQ to succeed over the very long term; I reference NDAQ’s 2023 Proxy Statement which includes an explanation of the Chair and CEO and Named Executive Officers (NEO) compensation.

In 2022, 88% of NDAQ’s NEOs’ total direct compensation was performance-based, or at-risk, and 64% of the NEOs’ total direct compensation was equity-based compensation. Total direct compensation includes base salary, annual cash incentive awards, and equity awards.

We do, however, see that the Chair and CEO’s ‘at risk pay’ is well above that of other NEOs.

Financials

Q2 and YTD 2023 Results

The Q2 and YTD2023 results released on July 19, 2023 are accessible here and the Q2 Form 10-Q is accessible here.

Although EPS fell to $0.54 from $0.62 in Q2 2022, this decline is primarily driven by $57 million in merger and restructuring charges.

In Q2, NDAQ’s anti-financial-crime segment produced another quarter of strong performance; the company’s underlying strategy for the segment appears to be working.

In February 2021, NDAQ completed its ~$2.75B acquisition of Verafin, an industry pioneer in anti-financial crime management solutions. The purpose of this acquisition was to accelerate NDAQ’s ongoing evolution into a leading SaaS technology provider and to significantly strengthen its existing regulatory and anti-financial crime solutions. With this acquisition, NDAQ plans to expand Verafin’s capabilities to service global Tier-1 and Tier-2 banks and broker-dealers; many of these firms were already leveraging NDAQ’s technology to detect market manipulation and abuse.

In Q2 2023, NDAQ signed four Tier 1 and Tier 2 bank clients. Four new clients may not seem significant. However, the sales cycle for larger clients is lengthy. Success breeds success and I anticipate the signing of new clients will accelerate once NDAQ’s prospects observe the frequency in which Verafin helps its clients strengthen their regulatory and anti-financial crime solutions.

Debt increased by $4.823B versus Q1 2023. This was due primarily to $5.016B net debt issued for Adenza financing, a $13 million increase in Euro bonds book values caused by a stronger Euro. This was partially offset by a net paydown of $0.207B of commercial paper.

Free Cash Flow (FCF)

Various investor platforms reflect NDAQ’s FY2013 – FY2022 FCF as being (in millions of $) 459, 492, 594, 642, 765, 917, 836, 1,064, 920, and 1,554. YTD2023 FCF is 900.

NDAQ, however, calculates its FCF by taking into consideration a couple of additional items (see below). As a result, NDAQ considers its FCF in recent years to be different from the figures reflected above.

In FY2022, it returned ~$0.38B in dividends to shareholders which was 26% of FCF. It also expended ~$0.23B to offset employee-related dilution. That left it with ~$0.8B in FCF to use for other strategic and investor return activities.

Expectations are for Adenza to generate ~$0.3B in unlevered pre-tax cash flow in the first year following the acquisition. The debt financing for the Adenza acquisition, however, is likely to result in an annual interest payment of ~$0.325B which is more than Adenza’s current free-cash flow. However, as Adenza grows and debt is reduced, Nasdaq expects incremental FCF from the addition of Adenza to fund incremental debt repayment and share buybacks; management expects ~$0.7B in excess annual FCF beyond the dividends and employee-related buybacks. This amount is expected to grow commensurately with earnings growth over the next few years.

FY2023 Guidance

NDAQ has narrowed its 2023 non-GAAP operating expense guidance by $30 million to $1.785B – $1.815B. The midpoint of the expense guidance range represents an annual expense increase of just below 5% for 2023. The decrease in expense growth expectations primarily reflects the impact of the decision related to the redesign of NDAQ’s digital assets offering as well as the adjustment to the incentive compensation program.

Assuming stable performance and exchange rates, expectations are for 2023 expenses to be near the middle of the updated guidance range. Additionally, due to the timing of expected expenses, it is expected that there will be a greater sequential increase in expenses in Q3 than in Q4.

The FY2023 non-GAAP tax rate is expected to be 24% – 26%.

Credit Ratings

Immediately upon announcing the Adenza acquisition, NDAQ’s domestic unsecured long-term debt was downgraded from Baa1 to Baa2 by Moody’s and from BBB+ to BBB by S&P Global. These new ratings are the middle tier of the lower medium grade investment grade category. They define NDAQ as having an adequate capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity for NDAQ to meet its financial commitments.

Despite the ratings downgrades, NDAQ has demonstrated its ability to reduce leverage within a reasonable timeframe following major acquisitions. Upon closing the Adenza acquisition, NDAQ’s capital allocation priority over the next 3 years will be to reduce Gross Debt / Non-GAAP EBITDA to 4.0X in 18 months and to 3.3X in 36 months.

I am prepared to give management the benefit of the doubt that it can replicate what it did following the two most recent large transactions despite a higher cost of capital environment than in 2017 and 2021.

Dividends, Share Repurchases, and Stock Splits

Dividend and Dividend Yield

Nasdaq’s dividend history is accessible here.

In Q2 2023, NDAQ returned $0.109B of cash to shareholders through the distribution of dividends.

My interest in NDAQ lies in its potential long-term TOTAL investment return. Its dividend metrics do not factor into my investment decision-making process.

On July 19, NDAQ declared its second consecutive regular quarterly dividend of $0.22/share on the company’s outstanding common stock. The dividend is payable on September 29 to shareholders of record at the close of business on September 15.

Using the current ~$51.50 share price, the dividend yield is ~1.7%.

With the issuance of shares to acquire Adenza, if all else stays the same, the dividend payment at the current payout of $0.22/share will increase to ~$0.51B annually.

Nasdaq plans to increase the dividend to achieve a 35% – 38% payout ratio over the next 3 or 4 years; this implies a ~10% CAGR in the dividend payout ratio over this timeframe. Calculation of this payout ratio annualizes the last paid quarterly dividend divided by the last 12 months of non-GAAP net income.

Share Repurchases

The weighted average number of shares outstanding in FY2013 – FY2022 (in millions of shares) is 514, 519, 514, 506, 509, 503, 501, 501, 505, and 498. For Q2 2023, this was 493.6.

As of June 30, 2023, there was $0.491B remaining under the Board authorized share repurchase program.

NDAQ’s weighted average shares outstanding will surge once it issues 85.6 million common shares to Thoma Bravo. However, NDAQ expects to partially offset deal dilution with additional buybacks. In addition, it will continue to repurchase shares to offset employee stock compensation.

After NDAQ’s leverage reaches target levels, the focus will be on using the vast majority of remaining FCF to execute share buybacks. Management states it does not anticipate making any significant acquisition-related capital allocation decisions that would deter the company from sizable stock buybacks over the coming years.

Stock Splits

NDAQ initiated a 3 for 1 stock split in 2022.

Valuation

In FY2013 – FY2022, NDAQ generated diluted EPS of $0.75, $0.80, $0.83, $0.21, $1.43, $0.91, $1.54, $1.86, $2.35, $2.26. Its diluted PE levels were 20.52, 17.70, 27.31, 23.63, 49.57, 18.25, 33.89, 24.31, 30.57, and 26.91.

When I reviewed NDAQ in my July 13 post, the forward-adjusted diluted broker estimates and valuation using my ~$51 purchase price were:

• FY2023 – 14 brokers – mean of $2.72 and low/high of $2.60 – $2.84. Using the mean estimate, the forward-adjusted diluted PE is ~18.75.
• FY2024 – 15 brokers – mean of $2.89 and low/high of $2.66 – $3.11. Using the mean estimate, the forward-adjusted diluted PE is ~17.6.
• FY2025 – 8 brokers – mean of $3.06 and low/high of $3.00 – $3.15. Using the mean estimate, the forward-adjusted diluted PE is ~16.7.

Using my ~$50.75 purchase price on July 19 and the forward-adjusted diluted broker estimates, NDAQ’s valuation was:

• FY2023 – 16 brokers – mean of $2.76 and low/high of $2.60 – $2.84. Using the mean estimate, the forward-adjusted diluted PE is ~18.4.
• FY2024 – 17 brokers – mean of $2.87 and low/high of $2.29 – $3.10. Using the mean estimate, the forward-adjusted diluted PE is ~17.7.
• FY2025 – 11 brokers – mean of $3.14 and low/high of $2.97 – $3.33. Using the mean estimate, the forward-adjusted diluted PE is ~16.2.

NDAQ’s current share price is ~$51.50. The valuation using the current forward-adjusted diluted broker estimates is:

• FY2023 – 13 brokers – mean of $2.78 and low/high of $2.60 – $2.86. Using the mean estimate, the forward-adjusted diluted PE is ~18.5.
• FY2024 – 13 brokers – mean of $2.88 and low/high of $2.50 – $3.10. Using the mean estimate, the forward-adjusted diluted PE is ~17.9.
• FY2025 – 9 brokers – mean of $3.17 and low/high of $2.99 – $3.35. Using the mean estimate, the forward-adjusted diluted PE is ~16.25.

Adenza is expected to become accretive to NDAQ’s earnings within 2 years. Until such time, NDAQ will be incurring acquisition and integration expenses that will likely exceed incremental earnings. On this basis, if I lower NDAQ’s mean FY2024 forward-adjusted diluted estimate by $0.30 to $2.58, the forward-adjusted diluted PE ratio becomes ~20 based on the current ~$51.50 share price. Lowering the mean FY2025 forward-adjusted diluted estimate by $0.15 to $3.02, changes the forward-adjusted diluted PE to ~17.1.

I consider these levels to be acceptable given NDAQ’s growth potential.

Nasdaq – Transforming Future Capital Markets – Final Thoughts

NDAQ conducted a strategic review of this business several years ago and the Evestment, Verafin, and Adenza acquisitions are part of NDAQ’s evolution to become a leading technology provider to the global financial system.

While Adenza is an expensive acquisition, I think it is a wise strategic move. Recent experiences in the global banking industry will undoubtedly result in increased regulatory reporting and risk management needs of major banks and brokerages.

NDAQ’s ‘Market Services’ segment’s revenue growth is likely to stagnate and management has identified a need to reposition the company to generate a greater degree of recurring revenue from a faster-growing line of business as opposed to transactional revenue. Following the 3 major acquisitions noted above, investors can expect most of NDAQ’s revenue growth to come from its ‘Financial Technology’ segment.

I do not like the degree of leverage NDAQ is taking on nor the downgrade in the credit ratings. However, I agree with management’s strategy of making transformational acquisitions as opposed to small acquisitions that will not materially impact the company’s direction.

Despite the significant increase in debt, NDAQ has demonstrated its ability to reduce leverage. NDAQ is committed to reducing leverage to 4.0x in 18 months and to 3.3x in 36 months at which time I expect rating upgrades from Moody’s and S&P Global.

Author Disclosure: I am long NDAQ. I disclose holdings held in the FFJ Portfolio and the dividend income generated from the holdings within this portfolio. I do not disclose details of holdings held in various tax-advantaged accounts for confidentiality reasons.

Author Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.

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