The LSE’s retail bond deal: why shareholders should sharpen their pencils, and then their knives

Thursday, December 6, 2012 5:25 AM

Last month the LSE issued a £300 million retail bond paying 4.75% interest for 9 years. The borrowing would, they said, “increase facility headroom” or, in other words, give the company room to maneuver in (unexplained) circumstances that would affect their capital position. Shareholders leaned forward aghast. After all, this is supposed to be a highly stable company, right? It’s profitable and even pays a dividend. So why are they raising money now? And why telegraph a kind of desperation?

Shareholders know that the economy remains so weak that interest rates hover at record lows, which is why they liked their equity in the LSE. And that gets the same investors wondering: in an almost zero-rate environment, why would the company (which they own) pay new bondholders money that could have been retained earnings to boost the stock? Or could have been used to increase their dividend? What was it really for, they want to know?

Interestingly, just as the LSE was hitting markets for cash, Amazon was issuing institutional bonds in the US. The internet retailer’s $3 billion offering came in three tranches, with the closest comparison being 10-year paper that yielded only 2.6%. That 2+% difference means £60 million extra the LSE would be paying over the life of their bond if they had been able to secure the better terms.

Now Amazon is a larger company, of course, and in a different business. It’s also been loss-making in its most recent results; it pays no dividend, and it competes in tricky marketplaces for razor thin margins, having to constantly deliver real returns through expansion and innovative new services. There’s a real risk that it will fail to do so. In contrast, the overwhelming majority of the LSE’s business continues to derive from its historic monopolies in UK and Italian cash equities.

A reasonable argument could be made that the LSE should be able to borrow on similar terms to Amazon. (Note to LSE shareholders: don’t even think about comparing stock price performance; you’ll become unwell.) Unless, that is, there are also substantial risks to the company’s future. And there are.

Yes, the LSE continues to rely on risky post-trade businesses, a profit line they even hoped to ratchet higher with their LCH purchase. Yes, their historic dominance in cash equities trading may fall further against rivals whose cost bases are a tiny fraction of their own. Yes, they may face rebellion (or regulation) over data charges. But the real danger is the company’s failure to deliver in two areas that management regularly highlight as strategic priorities: derivatives (where they have failed comprehensively) and bonds.

Hang on, you say. Didn’t they just report “good progress” with their retail bond initiative? Yes, and that was earnings-speak which, when translated into English, means: “This business, which had been completely meaningless, has grown but remains utterly negligible.”

In fact, their most notable success in retail bonds has been...their own issuance.

That’s right, when you trumpet a major initiative and it’s failing, what do you do? You advertise! “Look, everyone, it’s easy to raise cash in this new market! We just did!” The problem is that to make its poster the LSE had to give terms so compelling that the deal couldn’t fail. Surprised that the whole offer was snapped up? Don’t be: it was mis-priced to sell. After all, management knew they had to finally succeed, and it’s not like they were spending their own money.

At anywhere between £60 and £120 million, that would be an expensive marketing campaign, but the whole exercise would have served other objectives, too, some of which may be even more unsavory to investors. After all, when bond issuance frees up cash, the loot has a way of getting stuffed in executives’ stockings. If the market sees evidence of that, the bottom’s going to drop.

With the LSE’s stock substantially off recent highs and poised to fall further, management’s claim that they’re knocking the cover off the ball is starting to rile shareholders who feel more like they’ve been caught behind.