Added Nasdaq To The FFJ Portfolio

I last reviewed Nasdaq, Inc. (NDAQ) in this October 21, 2021 post. Based on my analysis, I decided not to initiate a position.

Fast forward to June 12, 2023. NDAQ has 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.

You may recollect that Intercontinental Exchange, Inc. (ICE), the owner of the NYSE, acquired Ellie Mae, the leading cloud-based platform provider for the mortgage finance industry from Thoma Bravo, in September 2020 for ~$11B.

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).

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

Now that NDAQ has restored its leverage to ~2.6X, it is embarking on another acquisition to accelerate its transformation into a leading technology provider to the global financial system.

On the morning of the Adenza acquisition announcement, NDAQ's CEO was interviewed on CNBC Television. This interview is accessible here.

In addition to this interview, details of the Adenza acquisition are found in this Press Release and Presentation; the transaction is subject to regulatory approvals and other customary closing conditions and is expected to close within 6 - 9 months.

A high-level overview of the industries Adenza serves and the services it provides is found on the company's website.

Adenza is expected to generate ~$0.59B of FY2023 revenue ($0.519B in FY2022), ~15% organic revenue growth, ~18% annual recurring revenue growth, and an adjusted EBITDA margin of 58%.

The addition of Adenza is projected to enhance NDAQ's strong financial profile by growing Solutions Businesses revenue from 71% of total revenue to 77% in 2023, increasing adjusted EBITDA margin to 57%, and adding ~$0.3B of annual unlevered pre-tax cash flow.

Based on the ~$10.5B purchase price, NDAQ is paying ~17.8X Adenza's forward revenue and ~31X the estimated FY2023 EBITDA or 26X when adjusted for NDAQ's projected expense synergies.

This is an expensive acquisition, however, NDAQ expects Adenza to become earnings accretive within 2 years.

The customer base is growing and Adenza boasts a 98% gross retention rate, a 115% net retention rate, and a durable mix of ~80% recurring revenue.

• Gross retention is calculated as Annualized Recurring Revenue (ARR) in the current period over ARR in the prior year period for existing customers excluding price increases and upsells and excluding new customers.
• Net retention is calculated as ARR in the current period over ARR in the prior year period for existing customers including price increases and upsells and excluding new customers.

Acquisition Financing

Financing of this ~$10.5B acquisition will be comprised of $5.75B in cash and 85.6 million shares of NDAQ common stock with the value of the common stock being based on the volume-weighted average price per share over 15 consecutive trading days before signing the agreement.

Fully committed bridge financing for the cash portion of the consideration has been obtained and NDAQ plans to issue ~$5.9B of debt between signing and closing; the debt proceeds will replace the bridge commitment.

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

Following the closing of this transaction, management anticipates NDAQ's leverage will increase to ~4.7X Gross Debt / Non-GAAP EBITDA. While NDAQ is committed to reducing leverage to 4.0x in 18 months and to 3.3x in 36 months, the increase in NDAQ's leverage has resulted in the downgrade of its domestic unsecured long-term debt credit ratings (see Credit Ratings section below).

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 their compensation structures, 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

Q1 2023 Results

The Q1 2023 results released on April 19, 2023 are accessible here.

In 'Section 8. Debt Obligations' commencing on page 16 in the Form 10-Q, we find the details of the Senior Unsecured Notes. The interest rate environment has changed considerably from the time these Notes were issued. It will be interesting to see what rates NDAQ can negotiate for the Adenza-related financing.

Q2 ends at the end of June and given the recent acquisition announcement, I dispense with any review of Q1 2023 results.

Free Cash Flow (FCF)

In FY2013 - FY2022, NDAQ generated FCF of (in millions of $): 459, 492, 594, 642, 765, 917, 836, 1,064, 920, and 1,554. In Q1 2023, it generated ~525.

FY2023 Guidance

The Adenza acquisition is expected to enhance NDAQ's results as shown below.

Credit Ratings

NDAQ's domestic unsecured long-term debt is being 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.

I think the only other instance where I invested in a company when its credit ratings were downgraded is when I invested in Becton Dickinson (BDX). I initiated a BDX position in February 2009 at which time its domestic unsecured long-term debt was rated A2 (the middle tier of the upper medium grade investment grade category). BDX subsequently acquired Carefusion and CR Bard and Moody's ultimately dropped its assigned rating to Ba1 which is the top tier in the non-investment grade - speculative category. BDX's management stated its commitment to restoring its credit ratings to investment grade and now the ratings are Baa2 and BBB (the same as NDAQ's recently lowered ratings).

Despite the ratings downgrades, NDAQ has demonstrated its ability to reduce leverage within a reasonable timeframe following major acquisitions. 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

NDAQ's dividend history is accessible here.

The ~1.7% dividend yield is based on the current $0.22/share quarterly dividend and my recent ~$51 purchase price.

NDAQ intends to make no changes to its capital allocation priorities which are reflected in the April 2023 Investor Presentation.

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. At the end of Q1 2023, this had been lowered to ~490.

NDAQ's weighted average shares outstanding will increase as a result of shares being issued for the acquisition. However, NDAQ expects to partially offset deal dilution with additional buybacks. In addition, it will continue to repurchase shares to offset employee stock compensation.

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.

Earnings estimates are likely to be amended as more information becomes available on the cost of financing this acquisition. For now, however, the current forward-adjusted diluted broker estimates and valuation using my ~$51 purchase price are:

• 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.

The acquisition is likely to close in 6 - 9 months (end of 2023 or early 2024) so the current FY2023 forward adjusted diluted earnings estimates are unlikely to be revised significantly in the coming weeks.

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, let's lower NDAQ's mean FY2024 forward-adjusted diluted estimate by $0.30 to $2.59. The forward-adjusted diluted PE then becomes ~20 based on my $51 purchase price. If the current mean FY2025 forward-adjusted diluted estimate is lowered by $0.15 to $2.91, the forward-adjusted diluted PE then becomes ~17.5 based on my $51 purchase price.

I consider these levels to be acceptable.

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.

I view this as an opportunity to invest in what is likely to become a very different NDAQ from that of the past. On June 12, 2023, I purchased 500 NDAQ shares @ ~$51/share through a 'Core' account within the FFJ Portfolio.

I wish you much success on your journey to financial freedom!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclosure: I am long NDAQ.

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.

I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with any company mentioned in this article.