Bidders for the London Metal Exchange (LME) may need to slash costs, boosting electronic trading and shifting to self-clearing to justify a rich price tag of 1 billion pounds or more.
Some of the changes might not take place immediately as bidders seek to reassure wary LME members that own the world's premier exchange for industrial metals, said analysts and experts who crunched numbers and looked at previous takeovers of commodity exchanges in developing the scenarios.
Plans by one of the potential suitors, InterContinental Exchange
A takeover could also mean eventually scrapping open outcry trading at the LME, one of the last bastions of floor trading, several of them said.
The LME declined to comment.
Bidders include ICE, CME Group
In late February the LME board considered a first round of non-binding bids, and last Wednesday both ICE and CME left doors open for making a bid.
But paying 1 billion pounds - a price that has been floated by industry sources since the LME received initial offers in September - and upwards is unlikely to be attractive given the present set-up of the LME which has kept fees low for members and generates modest profits.
That price tag would mean a valuation ratio nearly four times the level of other exchanges, based on estimated LME volumes and profits last year, according to analysts.
The LME is run as a club really, so if it were to be acquired you would have to ramp up the fees, whoever bought it, said Herbie Skeete, managing director at exchange consultants Mondo Visione.
The 135-year-old LME announced fee increases in December, but had to modify them amid opposition by members.
Skeete said the need to hike fees would also apply to possible bidders in Asia, such as the Hong Kong Exchange, which has said it wants to expand beyond equities into commodities and financial derivatives.
Sam Hilton, an analyst at brokerage Keefe, Bruyette & Woods in Hong Kong, said any deal for the Hong Kong Exchange would hinge on financial details.
Ultimately, it comes down to pricing. Are they also able to convince LME shareholders they're a worthy partner that brings enough to the table? On the face of it, it's not a slam dunk. But the China story is a very attractive one, and that may be able to work its magic.
END OF OPEN OUTCRY
To make an LME takeover generate value, bidders would likely follow a pattern of previous acquisitions of commodity exchanges, such as ICE's purchase of the New York Board of Trade (NYBOT) in 2007 for $1 billion, analysts said.
ICE squeezed out more profits after buying NYBOT, which like the LME, also used pit trading, according to analyst Niamh Alexander at Keefe, Bruyette and Woods in New York.
Within the two years of acquiring NYBOT, ICE had moved the majority of that soft commodity complex volume onto screens, effected fee increases, and brought the products onto its own central clearing house, he said in a research note.
In March 2008, ICE ended open outcry trading on all its U.S. futures contracts and shifted to fully electronic futures transactions.
Some LME members are worried that a bidder would scrap the current structure, under which LME contracts can be traded for delivery almost any business day forward for the first three months.
A buyer might choose to shift the structure to that of a standard futures market with only one prompt date per month to allow integration into existing electronic trading systems.
At NYBOT, a combination of higher volumes and hiked fees doubled transaction revenue from its agricultural complex by 2008 to $146 million, Alexander said.
The resistance by LME broker-members to fee hikes shows the obstacles any suitor will face, and analyst Christopher Harris at Wells Fargo Securities said bidders may have to consider innovative structures.
In 2009, ICE acquired The Clearing Corporation, a platform for credit default swaps (CDS), owned by dealers, after it agreed to share profits.
It could... result in the deal being structured similarly to The Clearing Corporation transaction in which some profits are shared with dealers, Harris said in a note, which noted that Wells Fargo has provided investment banking services to ICE.
He estimated an exchange such as ICE or NYSE Euronext, which already has infrastructure in the UK, could cut costs at the LME by 50-75 percent while Alexander pegged the potential to cut expenses at around 25 percent.
Analyst Alex Kramm at UBS in New York has estimated potential synergies, including cost cutting could amount to $70 million a year, more than doubling LME net profit to $68 million, based on estimated 2012 earnings.
That $70 million of synergies includes $26 million from the LME clearing its own trades, a major change from the current set-up under which business is cleared by LCH.Clearnet.
The clearing synergies would be especially attractive to ICE, which already owns an established clearing house in Europe and CME, which recently launched one in the region.
The Hong Kong Exchange runs its own clearing house and sees clearing over the counter derivatives as a growth area.
A deal would be most accretive to ICE because it would have the most excess cash available in June when a deal is expected to be concluded, Harris said.
ICE could finance a $1.6 million deal half with cash and half with debt, while the CME could find cash for a quarter of the value and use 75 percent debt and NYSE Euronext would likely use debt for 100 percent of the transaction, he added.
(Additional reporting by Kelvin Soh in Hong Kong, editing by William Hardy)