The market that defined the ‘90s stock craze is stumbling in a scarier age. But CEO Wick Simmons still wants to plow ahead with Nasdaq’s bull-market dream: go public and build a global, 24-hour exchange.
By Justin Schack
September 2002
Institutional Investor Magazine
Consider this prospectus for an initial public offering: A onetime highflier with ambitious plans for overseas expansion has fallen on tough times. Revenues have stalled, and earnings have plunged 34 percent in the first half of 2002. The company posted a loss, its first ever, in last year’s fourth quarter.
Among the major risk factors: The company is steadily losing market leadership in its primary business. Its major sources of revenue are under competitive pressure. And the protected regulatory environment for its business is disappearing.
Care to buy some shares?
No, this is not some concept stock floated at the height of the tech bubble. It is, rather, the market in which many such stocks were launched: the Nasdaq Stock Market, which hopes to launch its own IPO before the end of this year.
A pipe dream? Not according to Hardwick (Wick) Simmons, the former head of Prudential Securities, who became Nasdaq CEO in February 2001 and added the title of chairman in October. Simmons is betting that investors will be willing to look beyond a recent litany of woes. He believes that the fundamentals underlying Nasdaq’s spectacular growth in the 1990s -- the democratization of investing, the power of technology to speed historical economic growth rates and Nasdaq’s brand identification with both of these phenomena -- have an appeal that outshines the current downturn. So rather than discard the grand vision of his predecessor, Frank Zarb, Simmons remains committed to going public and going global. Nevertheless, Nasdaq is cleaning up its balance sheet and retrenching somewhat. Last month Simmons announced that Nasdaq would write off its $20 million investment in the money-losing Nasdaq Japan and withdraw from that market.
This month the company hopes to launch SuperMontage, the trading platform that Nasdaq believes will catapult it into the technological lead. It has spent three years and $100 million developing SuperMontage, with the goal of winning back the nearly 50 percent of Nasdaq trade volume lost to nimbler alternative trading systems over the past five years. Despite winding down Nasdaq’s three-year-old Japanese venture, Simmons continues to pursue a merger with an established European exchange to jump-start Nasdaq’s moribund expansion there. And, sources say, in recent informal presentations to institutional investors, he has reiterated the improbable target of late 2002 for an IPO.
“The markets are going to turn. They always do,” says the confident Simmons, a 32-year Wall Street veteran who has seen his share of booms and busts. “When the first company decides to step up and commit to that new capital spending, others will follow and we’ll get into another major round of growth. I sense that coming. But just hoping for a turn in the cycle is not enough. You have to ask yourself, ‘Am I willing to be out front, or will I be playing catch-up?’ All the stuff we have going at the moment are all things we must have in place, even though we may be early.”
Early? Most observers would say too late. If Nasdaq does go public this year -- and given today’s markets that doesn’t seem very likely -- it will do so in an environment that is wildly different from the one in which the plan was originally hatched. “They’re kinda still chasing the dream that everyone else gave up on when the bubble burst,” says one head of trading at a large Nasdaq member firm, who spoke on condition of anonymity.
Just three years ago -- okay, it seems like a lifetime -- the over-the-counter market glittered. Led by tech powerhouses like Cisco Systems, Intel Corp. and Microsoft Corp., Nasdaq seemed to be the market. Dismissed at its creation in 1971 as a risky market, with no trading floor and a laughable collection of microcap stocks, it had emerged as a legitimate rival to the venerable New York Stock Exchange. It seemingly added two or three new IPOs to its roster of dues-paying companies every day, while the Big Board struggled to remain relevant in the information age. Flush with listing and transaction fees, Nasdaq acquired the American Stock Exchange in a bold challenge to the NYSE and embarked on a series of deals to launch sister markets in Europe and Japan. The goal: to connect them and create a dominant, 24-hour exchange where the world’s most forward-thinking companies and investors would meet. In slick television advertisements Nasdaq touted itself as “the stock market for the 21st century.”
But the 21st century hasn’t turned out the way Nasdaq envisaged. Postbubble, far fewer companies are going public on Nasdaq, which has captured only a little more than half of the paltry 53 U.S.-company IPOs so far this year. The NYSE actually has an outside chance at finishing the year with more debut offerings, something it hasn’t done in more than a decade. Making matters worse, Nasdaq has had to delist 148 of the 2,651 IPOs it added since 1995 because of bankruptcies, exceedingly low stock prices and other violations of its already liberal listings standards, according to New York market data provider Dealogic. Mergers and acquisitions erased an additional 732 listings. At the same time, healthy Nasdaq companies such as E*Trade Group and Krispy Kreme Doughnut Corp. continue to defect to the more prestigious Big Board at the rate of about 30 per year. Nasdaq’s parent, the National Association of Securities Dealers, is looking to spin off the beleaguered Amex, an acknowledgement that the highly touted acquisition was a spectacular bust. And Nasdaq’s efforts to establish a beachhead in overseas markets have fallen far short of expectations in the face of competition from local exchanges in Europe and a dismal Japanese economy.
Nasdaq’s biggest problem, in a nutshell, is that it likely will never again grow as fast as it did when IPOs and trading volume reached freakishly high levels in the late 1990s. Yet it remains largely hitched to a corporate strategy devised in those boom times.
“Nasdaq is under a great deal of pressure, no question about it,” says Glenn Schorr, an analyst who follows the securities industry and alternative trading systems for Deutsche Bank Securities. “To some extent they are still living with a strategy that was a product of the boom years, and they’re going to have to adjust it to reflect a new market reality.”
NASDAQ HAS COME A LONG WAY FROM ITS humble roots. Its automated trading system debuted in February 1971, the product of a decade-old initiative by the Securities and Exchange Commission to centralize and improve trading of shares in the fragmented OTC market. Before the National Association of Securities Dealers Automated Quotation system, dealers literally processed transactions in these lightly traded stocks on conveyor belts: Brokers filled out paper order tickets, which went down the line to trading clerks, who would time-stamp them, then to traders, who would find counterparties by thumbing through pink stapled sheets of paper with price quotations that were updated weekly. Nasdaq allowed for quotes to be continuously updated by computer.
Nasdaq’s market makers were a rough-and-tumble lot, mostly upstarts operating on the fringes of the securities industry -- not the elite firms doing business on the clubby New York Stock Exchange. But life was good on the fringes. Dealers such as Mayer & Schweitzer, Troster Singer and Herzog Heine Geduld made a bundle putting their own capital at risk to bridge the exceptionally wide spreads on bid and ask prices on shares. And they looked out for one another: Gift deliveries of color TVs and cases of scotch whiskey were common around holiday time, say longtime traders.
“The over-the-counter trading environment was always sort of that way,” says Lon Gorman, a 30-year OTC veteran who heads the capital markets division of Charles Schwab & Co., which bought Mayer & Schweitzer in 1998. “There was a lot of reciprocity, favors, presents, back-room type of stuff.”
Nasdaq grew up fast during the bull market as its listed companies, many of them high-tech outfits, became more prominent and influential in the global economy. Big brokerage firms like Merrill Lynch & Co. and Goldman, Sachs & Co. moved in, making markets in hundreds of Nasdaq stocks. But the success was not unalloyed: Dealers colluded to keep spreads wide until a severe crackdown by the SEC and a suit alleging price-fixing by the Department of Justice. A group of market makers settled the suit in 1998, paying $910 million in fines.
The price-fixing scandal ushered in a new era and a new management team, led by the ebullient Zarb. A free-market champion and longtime brokerage executive at what is now Citigroup’s Salomon Smith Barney unit, he was eager to steer Nasdaq away from its roots as a government-mandated monopoly dominated by back-slapping dealers and toward a future as a vigorous, for-profit company.
Zarb wasted no time overhauling the structure of the market, implementing new SEC-mandated order-handling rules designed to make trading more transparent for individual investors, braving opposition from market makers. In 1999 he began moving the bulk of its operations from Washington, D.C., to New York. In Times Square he built a virtual home base for the floorless market, dominated by a 10,800-square-foot video screen, the world’s largest. He accelerated a costly national television advertising campaign, touting technology companies like Dell Computer Corp. and Qualcomm as Nasdaq’s stars. Football fans tuned in to the “Nasdaq halftime report” during network game broadcasts. The market spent a whopping $184 million on marketing and advertising from 1997 through 2001. With Nasdaq a household name among U.S. investors, Zarb set out to replicate the market overseas, launching Nasdaq Japan and Nasdaq Europe during that same dizzying year, 1999.
“We saw that the democratization of the marketplace which had started in the U.S. was beginning to happen elsewhere in the world, and Nasdaq had to look at how it would respond,” says Zarb, who now serves as chairman of insurer American International Group’s executive committee.
Then things began to unravel. New regulations required market makers to reveal on Nasdaq’s screen-based quote montage system any open customer orders that would improve the best available bids or offers. Lacking the technology to comply, most dealers began shipping orders to alternative trading systems, called electronic communications networks, loosing an array of more nimble competitors.
The ECNs, allied with online brokerages, marketed directly to investors for order flow and provided cheaper and faster execution, cutting into Nasdaq’s market share. Nasdaq struggled to improve its technology to keep up with surging bull market volume. But outages plagued the various systems it had in place to display and execute orders, exacerbating the loss of market share to ECNs. By the market’s peak in March 2000, almost 40 percent of trades were being done by ECNs, which had begun applying to the SEC to become exchanges. This would allow them to sell the market data they produced rather than ceding ownership of it to Nasdaq.
Zarb’s expansion plans, coupled with the competitive threat posed by ECNs, fueled his desire to spin off from the NASD and become a publicly traded company. A spin-off would free Nasdaq from NASD members -- the market makers who had resisted transparency tooth and nail because they perceived it as a threat to their lucrative trading fees -- and separate Nasdaq from its regulator, the NASD. Going public would give it a currency with which to attract talented employees and acquire other market centers, many of which were already publicly owned or going through similar demutualizations. Shedding the NASD’s quasigovernmental bureaucracy would also help Nasdaq adjust to losing its monopoly in over-the-counter trading.
“When I first started here, it was economists and lawyers in Washington, D.C., sitting in rooms and thinking through all the nuances of regulation and market structure, obeying rules,” recalls Dean Furbush, the head of Nasdaq’s transaction services unit, who joined the NASD as chief economist in 1995. “Now we’re focused on customers and shareholders -- on the bottom line.”
In June 2000 Nasdaq sold 23.6 million of its common shares to NASD members, market participants and listed companies at $11 per share, as the first step in demutualization. In January 2001 a second private placement of 5 million shares at $13 each completed the spin-off. In March private equity firm Hellman & Friedman -- in which Zarb became a limited partner upon leaving Nasdaq last fall -- invested $240 million for a 10 percent stake in the market. The share registration statement Nasdaq filed with the SEC contains ten pages of risk factors for prospective buyers to consider. Nevertheless, in April 2001 Nasdaq’s board recommended that the new, for-profit company undertake an IPO.
Why now? Zarb, the man behind the strategy, stands to benefit handsomely from an IPO. According to Nasdaq’s 2002 proxy statement, the former chairman and CEO holds stock and options worth $13.6 million, based on the $13 share price used for the last private placement. Current management has incentives to stay the course. Simmons has options to acquire shares worth $26 million. His No. 2 executive, chief operating officer Richard Ketchum, has stock and options worth $5.2 million.
Applying the publicly traded London Stock Exchange’s price-earnings ratio of 22.5 to Nasdaq, one arrives at a share price of $18. The LSE faces far fewer challenges, but sources say bankers are nonetheless dangling a roughly equivalent P/E -- for an IPO price range of $15 to $20 -- in front of Nasdaq execs.
SIMMONS SUCCEEDED ZARB AS CEO in February 2001. From the start he had his hands full. Revenues fell. He needed to invest in new trading technology, while simultaneously cutting costs. He has lopped off 200 of 1,300 jobs, exited Japan and cut the budget of Nasdaq’s unprofitable European operations to devote more resources to battling ECNs in the U.S.
In July 2001 Nasdaq took one step in that direction by successfully launching an order-routing and execution system called SuperSoes, which replaced the often unreliable systems -- SelectNet and SOES -- that previously handled these functions. SOES, an acronym for small order execution system, was an automatic execution system for order lots below 1,000 shares, while SelectNet was an e-mail-based system for larger lots.
The next step is SuperMontage, which began live testing on July 29. The system provides instantaneous executions for orders of any size. It also permits institutional traders for the first time to see quotes and execute transactions other than the best bid and offer in a given stock. That should allow them to move larger blocks more efficiently because the best available prices are often for small lots of shares. Initial reviews of the system from traders are optimistic. After three years of development -- and two disastrous earlier efforts to create a centralized trading platform -- morale in Furbush’s transaction services unit is surging. “People are really pumped,” says Adena Friedman, an executive vice president in the division responsible for SuperMontage. “Finally, after all this time, all this work, all the complaints and the down times, it’s happening. It’s just a great time to be at Nasdaq.”
Maybe, but Nasdaq’s transaction services business -- fees for trades executed on its systems, which constituted its single largest source of revenue at $408.8 million, or 48 percent of the total, last year -- has an awful lot of ground to reclaim. It’s down 6 percent for the first half of 2002, to $207.8 million. In addition to competition from ECNs, Nasdaq also faces a potential challenge from its erstwhile stepsister, the Amex, which began last month trading Nasdaq stocks. It’s too early to tell how much market share, if any, the Amex might take away. Still, the move is yet another sign that competition in Nasdaq’s bread-and-butter business, over which it not long ago enjoyed a virtual monopoly, is getting more intense.
And the challenges for Simmons extend further. Nasdaq’s listings business, for instance, made up 18 percent of the company’s revenue last year, or $156.1 million. That’s down almost 50 percent from $305.2 million in 1999, when a whopping 485 companies went public on Nasdaq -- nearly ten times the number that debuted on the Big Board. Through July 31, 2002, there had been only 31 IPOs on Nasdaq, and IPO activity isn’t likely to recover anytime soon. Revenues for the listings business have increased 14 percent for the first half, but that’s because Nasdaq hiked listings fees at the beginning of 2002.
The exchange also faces uncertainty over its sales of market data. Last year the company took in $240.5 million -- 28 percent of revenues -- from hawking quotes and trade reports to data vendors, news organizations, online brokerage firms and investment Web sites. That’s one fifth of the total paid by users for Nasdaq data, because the market normally shares 80 percent of such fees with the market makers and ECNs that generate the quotes and “print” their trades using Nasdaq’s Automated Confirmation Transaction service.
Nasdaq justified skimming 20 percent off the top by saying that it required the money to fund the considerable regulatory infrastructure needed to keep the market fair and equitable. But buyers of the data have long complained that the fees Nasdaq charges are too high. And many Nasdaq members, particularly ECNs, believe that the market should share a higher percentage of this “tape” revenue with those who provide the data. Last December Island, a leading ECN, began printing its trades on the Cincinnati Stock Exchange, which at the time rebated trading firms more tape revenue than Nasdaq. Because Island then handled about 20 percent of the trades in Nasdaq-listed stocks, its move hit the bourse hard, con-
tributing to an 18 percent first-quarter decline in Nasdaq’s market data revenue compared with the same period in 2001.
In May Nasdaq fired back at Island by revamping its tape revenue-sharing model. It increased its user rebate to 90 percent from 80 percent. But it also created a new fee for all users to cover regulatory costs. The new fee will be higher for those, like Island, that choose to post quotes on Nasdaq’s system but print completed trades on other exchanges.
“There are arbitrages with smaller markets that don’t really carry out much in the way of regulatory duties right now that present us with some challenges from a tape revenue point of view,” explains COO Ketchum. “We think our unbundling of the charges and the costs of regulation addresses that.”
Nasdaq’s counterpunch, however, prompted an infuriated Island to rethink its earlier commitment to participate in SuperMontage. The ECNs are critical to the new system’s success because they do nearly half of Nasdaq trade volume. If they elect instead to quote prices in the Alternative Display Facility mandated by the SEC as a condition of approving SuperMontage, they could siphon off enough liquidity to hamstring the system, while further slicing into Nasdaq’s shrinking revenues from transaction services and market data. That danger is especially acute now that Island and Instinet, the largest ECN, are set to merge -- with Island’s fiery executives in charge of the merged company’s ECN business.
“If a couple of ECNs decide to get together, withdraw from SuperMontage and move to the ADF, it could be a major challenge for Nasdaq,” says Thomas Wright, head of U.S. equity trading at Merrill Lynch. “And it presents us with a very complicated situation. On the one hand, it will definitely bring costs down, which is good for our clients. But on the other, you will need linkages between those market centers.”
The situation grew even murkier on July 2, when the SEC eliminated the data- fee rebating programs in place at Nasdaq, the Cincinnati exchange and the Pacific Exchange, another regional market based in San Francisco. The commission grew concerned that some market partici-pants were abusing the rebating policies, through tactics such as “wash sales” and “shredding the tape.” In a shredding transaction, for example, a firm with an order to buy 1,000 shares of a stock at $10 might execute it in ten 100-share lots, all at the same price, just to maximize the per-trade rebates. That, the SEC fears, could mislead other investors into thinking there is more interest or liquidity in a given stock than actually exists.
For the moment the exchanges get to keep all the revenue, but that will likely change. The rebate plans may be reinstated if the exchanges’ proposals are open to public comment and SEC review. “We definitely will refile our program” with the SEC, says Jeffrey Brown, general counsel at the Cincinnati exchange.
The SEC action is part of a larger review of how market data is distributed, say people familiar with the matter. That review, these people say, will focus on what the SEC believes is the root cause behind abuses of the rebating policies -- that there is simply too much revenue generated from data sales in the first place. Indeed, exchanges have been under pressure to reduce data fees for many years, from investors and traders who argue that they are the ones generating the information. The SEC review may result in those critics finally getting their way. The upshot for Nasdaq: If it is able to reinstate its modified rebating policy, Island and other ECNs may bolt SuperMontage. Even if they don’t, selling market data probably will still be a far less lucrative business in the future. “We will still print on the Cinci,” even if rebates are not reinstated, says Island executive vice president Andrew Goldman.
One silver lining for Simmons may be Nasdaq’s booming business in exchange-traded funds, such as the Nasdaq 100 Trust, which encompasses the largest 100 nonfinancial stocks listed on Nasdaq and is known by its QQQ ticker symbol. Ironically, the Amex is the home trading market for the QQQ -- a vestige of the aborted Nasdaq-Amex Market Group that has since been unwound. But even though it doesn’t get much of the fund’s trading volume, Nasdaq makes quite a bit of money from licensing the Nasdaq 100 index to the Amex as the basis for the wildly popular ETF. As trading in the security has taken off, more market centers have asked for and been granted licenses -- Island and the NYSE among them -- creating a fourth source of revenue. Last year licensing brought in $51.8 million, 6 percent of Nasdaq’s top line. “We are planning to launch a whole series of these products in the near future,” a jubilant Simmons told attendees at a May cocktail reception for the third anniversary of the QQQ launch.
THE FUNDAMENTAL DILEMMA for Simmons is that with its core U.S. business facing long-term stagnation, Nasdaq needs a new direction. Hence his embrace of Zarb’s overseas strategy. He cites a statistic frequently used in Nasdaq marketing materials: Although 50 percent of U.S. individuals own stocks, less than 20 percent of their counterparts in Europe and Asia do.
But even if going global is a smart strategy that Nasdaq is capable of executing -- both debatable points -- Nasdaq’s woes in the U.S. may prevent Simmons from ever getting there. Because its efforts to build exchanges in Europe and Japan from the ground up have failed, Nasdaq must pursue a merger or acquisition to gain critical mass. Only an IPO will provide Nasdaq with the capital and acquisition currency it needs to accomplish these goals, especially because likely targets such as the London Stock Exchange and Deutsche Börse already are public companies.
Nasdaq will have an exceedingly difficult time selling shares in a public offering, however, unless it improves its revenues and earnings outlook. That’s iffy.
With transaction services accounting for nearly half of its revenues, Nasdaq must make a success of SuperMontage and reclaim market share from ECNs -- especially with the participation of major ECNs in question. “Instinet and Island combined would be not only our largest single contributor of orders, we hope, to SuperMontage, but also could be our largest competitor,” Simmons told concerned investors during Nasdaq’s second-quarter earnings conference call last month. “Whether they decide to join or fight will be very important to us going forward.” Already, Bloomberg Tradebook, an ECN with about 2.5 percent of Nasdaq volume, has committed to participate instead in the ADF.
That’s why, sources say, Nasdaq may be looking at buying one of the major ECNs before others ally and present more formidable competition. “We’re constantly looking at what we should be doing,” says Simmons. “We think SuperMontage is going to roll up some of the liquidity out there, but that doesn’t mean we shouldn’t try to enhance its volume by possibly doing something along those lines.”
Insiders say that some Nasdaq staff and management question whether going public will create an untenable conflict of interest: A publicly owned Nasdaq will have to deliver quarter-to-quarter earnings growth for shareholders, but also will have a responsibility to divert resources from the bottom line to ensure that the market’s infrastructure and oversight adequately protect investors. Zarb himself says he was initially deeply skeptical of going public for this reason, but over time became convinced that the two obligations were complementary rather than contradictory.
In any event, creating the world’s first global, 24-hour stock exchange appears to be an idea that is way ahead of its time. Nasdaq seems to have partially faced this reality by dismantling Nasdaq Japan. But Simmons says that establishing a beachhead there is still part of the company’s long-term strategy, and he continues to invest in Europe. In June Nasdaq launched a new exchange for trading German blue-chip stocks, in conjunction with the Berlin and Bremen stock exchanges, Commerzbank and Dresdner Bank. In Germany, however, the Nasdaq-like Neuer Markt has lost 90 percent of its market capitalization during the past year, with insolvencies among its once high-flying IPOs running rampant, leaving retail investors heading for the hills. “I’m not sure I understand all the benefits that they predict of a global, 24-hour, seven-day-a-week exchange,” says Deutsche Bank analyst Schorr. “It may make sense someday, but it’s not a necessity now.”
Nor will a successful SuperMontage system close the prestige gap that persists in the minds of corporate executives between Nasdaq and the NYSE. That’s especially true at a time of scandal and skullduggery, when “slow, steady and safe” holds a decided advantage in the court of public opinion over “unlimited upside.” The NYSE’s history and pedigree are hard to compete with.
“We didn’t really consider a non-NYSE listing with any seriousness,” says C. Edward Chaplin, senior vice president and treasurer of Prudential Financial, Simmons’ former employer, which went public on the NYSE in December. True, Simmons left the insurance giant after clashing with senior management over the direction of the securities unit he ran. But even if the break had been friendly, Pru wouldn’t have gone to Nasdaq, says Chaplin. “We expected to be one of the premier large-cap financial services companies out there, and the NYSE is just the place to be when you’re in that league.”
One IPO Nasdaq won’t have to battle the NYSE for is its own. But it has to overcome some pretty long odds before it can add that one to the list. This is no market for shaky stocks.
