Instinet Needs a Lot From Island

Updated from 8:20 a.m. EDT

Instinet's(INET) plan to turn 25% of itself over to acquiree Island has at least one analyst worried the company isn't getting enough earnings in return to support its already high valuation.

Merrill Lynch downgraded the publicly traded Reuters(RTRSY) unit to sell from neutral Monday, citing the potential dilution of the company's book value.

Shares of Instinet were nevertheless higher by 2.6% at $7.34 after earlier rising about 10%. Reuters shares were down 2.4% to $38.60. News of merger talks between Instinet and Island first emerged May 16.

Instinet, which is 83% owned by Reuters, said Monday it would acquire Island for stock worth $508 million. Instinet plans to issue 77 million shares to Island's existing stockholders and convert outstanding Island options and warrants into options and warrants to purchase about 9 million shares of Instinet. Instinet also said it would issue a special $1 a share dividend on all issued and outstanding stock, or about $249 million total. After the swap, existing Island stockholders will own about 25% of Instinet.

The deal is seen as creating a formidable threat to Nasdaq's SuperMontage system, scheduled to debut this summer.

Merrill analyst Judah Kraushaar said that while the deal will give the companies a competitive edge against Nasdaq and other electronic trading exchanges, he calculates that it will lower Instinet's book value by around 37% to $3.20 a share. Kraushaar also sees about a 10% return on equity for Instinet in 2003 following completion of the deal, "considerably lower than our estimated cost of equity."

In a conference call, executives said they expected annual cost savings from the deal of about $25 million in the areas of clearing, combining facilities, and shared corporate services and technology. Achieving these cost savings will result in one-time charges, the company said in a press release earlier Monday. Excluding the noncash costs and one-time charges, the company expects the merger with Island to be accretive within the first year after closing.

Kraushaar agreed the deal would be accretive to earnings, but worried that its valuation multiple, at 17 to 19 times 2003 earnings, is too high. The analysts sees a 5% to 13% accretion to his 2003 earnings forecast of 38 cents a share assuming $15 million to $30 million in pretax savings in the first year after the transaction. He estimates the stock price has 30% downside from current levels.

In a statement, Instinet and Island said the merger, which will consolidate two rivals who together handled 26% of total Nasdaq trading volume in May, will create "broader and deeper liquidity," offering better execution opportunities. Island Chairman Ed Nicoll said, "In combination, the new company will not only continue to deliver innovative products and services, but will set the standard for meeting the needs of a diverse group of traders and institutional investors worldwide."

The acquisition, subject to regulatory and shareholder approval, is expected to close in the second half of 2002.

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