As I am writing this article during Monday’s premarket action, the Nasdaq is rallying higher towards its September highs, in what it seems to be another green day to start the week.
The current market environment may be confusing for growth investors. At his point, many growth stocks rallying higher have been detached from any reasonable valuation metric. As a result, investors may find it difficult to identify a much-needed margin of safety in many equities.
In this article, we want to take a look at one stock that we believe offers both attractive growth prospects while enjoying robust cash flows, that are unlikely to deliver volatile future returns. We are talking about Nasdaq (NDAQ). Not the index, but the actual company behind it.
More specifically, we aim to:
- Explain why Nasdaq enjoys secured and reliable revenues
- Assess the company’s growth metrics and shareholder returns
- Conclude why Nasdaq offers adequate returns at a reasonable price.
Nasdaq – A oligopolistic growth machine
One of Nasdaq’s most charming characteristics is the company’s oligopolistic nature in a sector with massively high barriers to entry.
The company operates one of the few American stock exchanges. The sector is highly regulated, with the few, well-trusted market operators leaving no room for potential entrants. As a result, the company essentially faces no competition when it comes to its core operations.
As the pie chart displays below, the blue pieces comprise Nasdaq’s non-trading segments, which account for around 60% of revenues and its principal operations. For example, the Corporate Services division takes care of companies looking to IPO, while the Info Services segment collects fees for licensing Nasdaq’s indices and provides market data and analytics.
The company’s cash flows suffer little to no volatility because around 73% of its revenues are of recurring & subscription nature.
Source: Investor presentation
As the graph illustrates below, non-trading segments enjoy consistent organic growth with little volatility. Let’s take the company’s Info Services segment, for example, which includes Nasdaq’s licensing revenues. Companies who want to offer Nasdaq-branded indexes, associated derivatives, and financial products (e.g., a Nasdaq 100 ETF) must pay the company continuous fees that are also correlated to each product’s AUM.
Source: Q2 results
As a result, as the public markets grow larger over time, the company should keep on growing its recurring licensing fees with no extra effort. The company a particularly advantageous in that regard as some of the highest growth companies whose stocks (and hence Indexed AUM) are likely to appreciate higher (e.g., Amazon, Alphabet, Microsoft), are listed in its very own exchange.
Moving on, Nasdaq’s Market Services (gray pieces of the piechart) account for around 40% of its revenues and include
- Equity Derivative Trading and Clearing,
- Cash Equity Trading, and
- Trade Management Services
As the revenue growth chart illustrates above, this segment is a bit more volatile and subject to the market’s overall trading activity. However, this allows the company to generate superior sales during times of uncertainty, which naturally involves higher trading volumes.
Source: Investor presentation
Overall, with higher demand for the company’s market data and analytics, higher licensing fees, and increased volumes due to the market naturally growing larger, Nasdaq has been consistently growing its revenues.
Further, due to the company’s relatively passive and low-volatility business model, its gross margins have remained high and very consistent, only slightly dropping temporarily due to higher costs related to COVID.
Capital returns, Valuation, Investor returns
The company’s tangible capital returns are primarily through dividends. Stock buybacks have been relatively humble, with an annualized repurchase average of around $150M over the past few years, which corresponds to less than 1% of the company’s market cap.
In terms of dividends, the company has been increasing its distributions annually since 2014, while the current payout ratio remains quite flexible, at just 33% its underlying earnings.
Source: Seeking Alpha
Before we jump into our projected stockholder returns, we need to consider the stock’s valuation. As you can see, Nasdaq’s (forward) P/E ratio has been undergoing a prolonged multiple expansion. As a greater proportion of the company’s revenues have been transitioning towards recurring ones, investors have been willing to pay a higher price for more predictable cash flows. Still, we believe that Nasdaq’s valuation remains quite attractive, considering its moat and growth prospects.
We will now take into account the stock’s valuation and projected growth rates to estimate the potential shareholder returns.
Management itself forecasts around 5%-7% of organic revenue growth in its non-trading segments in the medium term. However, the actual growth should end up being quite higher, since Nasdaq has been acquiring other companies as well. Over the past year alone, the company has acquired/invested in five different companies, which should also contribute to its top line over time.
Source: Investor presentation
Additionally, EPS should grow faster than sales, since the company aims to grow its expenses at a more reserved rate over time. This has been the case over the past few years as well. Nasdaq’s current 10-year EPS CAGR has been around 14.7%.
Still, to be prudent, we will assume an EPS CAGR of 8% in the medium term. Further, we estimate a DPS CAGR of around 5%. It is a reasonable estimate since the company seems to be aiming towards maintaining a relatively low payout ratio.
By plugging in Nasdaq’s current stock price of around $125, our expected EPS & DPS growth rates, and a reasonable range of future valuations, we get the following expected investor returns:
As you can see, even if the stock’s valuation were to remain near the low 20s, investors are still expected to enjoy close to double-digit annualized returns. Further, the company’s valuation multiple is more than likely to keep expanding, as investors appreciate the safety of Nasdaq’s stable cash flows, willing to pay a higher price. In this scenario, current investors are likely to enjoy much higher returns, as you can see below.
Nasdaq operates in a massively regulated sector, with essentially no barriers to entry. The company has the ability to organically grow its cash flows, which are also incredibly secured because of their reccuring nature and the brand’s longevity in terms of licensing.
Overall, despite the fact that the company is not exponentially growing, its attractive forward valuation combined with dividends reinvested allows for more than adequate investor returns, including the valuation’s potential to expand further.
Combining everything mentioned with the fact that the Nasdaq’s trading-segment revenues will grow even higher if the market corrects at some point, offering a good hedge, we remain bullish and view the company as a great investment that combines predictable returns along with satisfactory growth.
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Disclosure: I am/we are long NDAQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.