This week, many investors are reading a Securities and Exchange Commission (SEC) registration statement (the document with which companies sell themselves on public markets for the first time) that sounds like the good old days.
"We operate an e-financial marketplace where buyers and sellers worldwide can trade directly and anonymously with each other, gain price improvement for their trades and lower their overall trading costs . . . We also provide our customers with access to research generated by us and by third parties, as well as various informational and decision-making tools."
As any good e-commerce analyst worth his severance package could tell you, this is a business-to-business exchange - a place where businesses can come to buy and sell a product or service without paying the inflated commissions of intermediaries.
Hundreds of such businesses have been set up since 1995. Some have gone bust; some are on the way to the same destination; some have gone public and experienced catastrophic falls in their stock prices. Very few are still on track.
Their common problem is that accumulating liquidity, the key to success, has proven more elusive and expensive than most believed possible. Investors who a year ago thought an exchange was worth several billion dollars, even though it was carrying few transactions, have had a substantial change of heart.
Yet this week, one company that shows how attractive a business-to-business (B2B) exchange can be when it achieves critical mass is going public. Instinet is a B2B exchange for shares and fixed-interest securities. Not only has it picked one of the world's biggest trading markets to operate in, it has also made meaningful inroads into that market and built a business that is profitable by anybody's standards.
In the latest version of its registration statement filed with the SEC, the company boasts that its share of all Nasdaq market trading has risen from 7.8 per cent to 8.9 per cent since 1995. Its net income last year was nearly $150 million (#170 million), and its top-line revenues (including so-called soft commissions, in which securities trading business is won by offering research in return) are well over $1 billion.
So this is a B2B exchange that has worked. Yet three things about it are remarkable. One is how long it has taken for the business to succeed: Instinet has been in place for more than 30 years. Another is that the early investors have not done very well. A third is that the company eventually achieved success by being the subsidiary of a much larger entity. The explanation for the last two points is that Instinet was bought by Reuters in 1987.
From a B2B investor's perspective, another point is even more startling. Reuters has made a handsome return on its purchase. It bought Instinet for a modest $102 million and is now floating a minority interest at a likely price that values the entire business at around $3 billion - in an initial public offering of which $150 million of the proceeds will go back to Reuters to return the capital originally injected by the parent.
Yet in contrast to the valuations placed on B2B exchanges last year, $3 billion is a bargain basement price. It may be unfair to make comparisons based on a price-to-sales multiple, since so many of the exchanges had negligible sales and were selling themselves to investors on the sizzle of their future growth. Instinet, by contrast, has expanded at an old-economy rate of 25 per cent a year for the past five years.
Does this mean, then, that frustrated Internet investors should pile into the stock as a proxy for what they once believed in? Probably not. For a start, Instinet has had its own management challenges over recent years. In 1998, seeing the spectacular success of start-ups such as E-Trade and spin-offs such as AmeriTrade (both of which I have held stock in for the past couple of years), the company began an expensive investment programme to build a retail online brokerage.
Gradually, however, it became clear that the marketing costs of building a brand would be unattractively high for Reuters' shareholders. At the end of last year, no doubt with the public offering in mind, Instinet pulled the plug on its retail ambitions, wrote off the money it had spent and decided to stick to its exchange operations.
Secondly, this is an alarming time in the economic cycle to be investing in a B2B exchange for the securities industry. As the company's prospectus makes admirably and honestly clear, its business depends not just on the level of transactions but also on the price of shares; in many international markets, its revenues are in fact directly related to the price of the transaction.
The result is that an investment in Instinet is a bet on the continuing health of stock prices in general and the Nasdaq in particular. Analysts may look at the offering and conclude that Reuters missed its market timing, since it could have floated Instinet at 10 times the price a year ago. Investors may wonder whether, if they like the business, the best way to voice their enthusiasm is to buy the stock but short the market.
tim.jackson@pobox.com
