NDAQ

Business Context and Reporting Period

Company: The Nasdaq Stock Market, Inc.
Filing Type: Form 10-Q (Unaudited)
Period Ended: September 30, 2005
Overview: Nasdaq operates the largest electronic screen-based equity securities market in the U.S. The company manages two primary segments: Market Services (trading and data) and Issuer Services (listings and financial products). The reporting period reflects significant operational changes, including the integration of the Brut ECN acquisition and ongoing cost reduction initiatives.

Key Financial Metrics

Note: Debt figures include $25.0 million in Senior Notes and $442.3 million in Convertible Notes as of Sept 30, 2005.

Material Changes vs. Prior Period

• Revenue Growth: Total revenues increased 77.8% year-over-year for Q3 and 66.6% for the nine-month period. This surge is primarily driven by the "gross-up" of execution revenues following a change in accounting treatment (EITF 99-19) and increased trading volume from the Brut ECN acquisition.
• Profitability Turnaround: The company moved from a net loss of $5.5 million in Q3 2004 to a net income of $17.8 million in Q3 2005. Operating income improved from a loss of $9.0 million to $31.4 million.
• Cost Reductions: Total direct expenses decreased 21.1% in Q3 and 14.1% YTD compared to 2004. Significant savings were realized in computer operations ($33.8M decrease YTD) and general/administrative expenses due to workforce reductions (headcount dropped from 891 to 759) and real estate consolidation.
• Accounting Change: Beginning April 1, 2005, Nasdaq began recording execution revenues on a gross basis and liquidity rebates as cost of revenues due to a new Limitation of Liability Rule. This significantly increased reported revenue and cost of revenue figures without changing the underlying economic gross margin.

Guidance, Outlook, and Risks

• Instinet Acquisition: Nasdaq has entered a definitive agreement to acquire Instinet Group (specifically the INET ECN) for approximately $1.878 billion. The deal is expected to be dilutive for up to 12 months post-closing but accretive thereafter due to technology synergies and cost savings.
• Financing: To fund the Instinet acquisition, Nasdaq issued $205 million in convertible notes and secured a $750 million senior term debt commitment. The company also restructured existing $240 million convertible notes.
• Regulatory Environment: The SEC's adoption of Regulation NMS (effective mid-2006) poses significant risks, potentially altering market structure, reducing fee flexibility, and impacting market data revenues. Nasdaq is also pursuing registration as a national securities exchange to separate from the NASD.
• Competition: Intense competition persists from other exchanges (NYSE, Amex) and new entrants (Boston Equities Exchange). Aggressive price cutting in trade execution fees continues to pressure margins.
• Unusual Items: The company recorded a $7.4 million pre-tax charge related to the restructuring of convertible notes and a $1.8 million charge for the change in fair value of preferred stock payments to NASD.

Investor Verification Checklist

• Instinet Closing Conditions: Verify the status of regulatory approvals (SEC, HSR Act) required to close the Instinet acquisition.
• Regulation NMS Impact: Assess the potential long-term impact of the Order Protection and Access Rules on Nasdaq's market share and fee structure.
• Debt Service Capacity: Review the company's ability to service the new $750 million senior term debt and the $205 million convertible notes, particularly given the expected short-term dilution.
• Revenue Quality: Distinguish between organic growth and the accounting-driven revenue increase caused by the shift to gross reporting of execution fees.
• Cost Synergies: Monitor the realization of projected cost savings from the Instinet integration and the migration to the INET trading platform.