This article was written by Peter Shearlock and published in The IRS Report in August 2011.

Tullett overlooked in a consolidating sector

Some of the world's biggest markets are all but invisible to the ordinary investor. Take foreign exchange and interest rate swaps. These instruments are traded between banks and other professional investors "over the counter" (OTC). That is to say they are not listed on any exchange. Yet the market is huge. The notional value of outstanding OTC contracts tops $600 trillion. Interest rate swaps make up more than half of that figure.

The middle-men in these markets are called inter-dealer brokers. They provide liquidity and anonymity to buyers and sellers. As the OTC markets have expanded, so has their role and importance. They do well in times of volatility, when sharp price movements tend to boost trading volumes, and all are benefiting from the rise in trading in regional products in places such as Asia and Latin America.

Two of the biggest are UK-quoted companies. The most successful of these is ICAP, which is run by Michael Spencer, former treasurer of the Conservative Party. The other is Tullett Prebon, whose chief executive is Terry Smith, former head of stockbroker Collins Stewart, which was demerged from the then Collins Stewart Tullett in 2006. Smith last year founded his own investment management company, Fundsmith.

In valuation terms, Tullett Prebon lags ICAP by a long way. That is not entirely surprising as ICAP has led in the development of screen-based markets for OTC products, most recently for interest rate swaps. Tullett Prebon is currently rolling out its own electronic platform for euro interest rate swaps, tpSWAPDEAL. Tradition, the Swiss inter-dealer broker, launched its own platform, Trad-x, some months back.

But is there really any reason why Tullett Prebon shares should sell for not much over seven times earnings and ICAP's for nearr 12? My own view is that the gap should narrow - and I have bought some shares on that basis. I see Tullett Prebon as an attractive value stock. Both companies are subject to the same market pressures and while Tullett Prebon is still more dependent on voice broking - trading by phone or "sqawk box" rather than on-screen - it looks as if it is catching up. The firm also recently completed the acquisition of a leading Brazilian inter-dealer broker, which gives it an important toe-hold in a fast-growing market.

Unlike ICAP, however, Tullett Prebon is a perennial takeover candidate. In the past 18 months, it has been engaged in merger talks twice. The first time it was the target following an approach from an unnamed suitor. Earlier this year, it was in discussions with Tradition. That would have been a merger, with Tullett Prebon probably coming out on top. Again, the talks foundered.

That is unlikely to be the end of the story. In the biggest shake-up the wholesale markets have seen, regulators on both side of the Atlantic are planning to shift trading in some of the more standardised OTC derivatives onto exchanges or "execution facilities". Deals will be processed and cleared through central clearing houses - in the same way listed shares are. The timing of these changes remains uncertain. In the US, regulators face a mammoth job rewriting their rulebooks and have already missed one deadline. In Europe, nothing will happen before 2013 at the earliest.

Tullett Prebon has said its "offering can be developed to meet the requirements being proposed". But the betting is that the changes will lead to more consolidation in the industry. They could also encourage one or more of the leading stock or futures exchanges to buy an inter-dealer broker and use it as a launch pad for entering these enormous markets.

Tullett Prebon produced its half-year figures last week. There was a slight slowdown in market activity in the second quarter of the year, though indications from the likes of ICAP suggest early-summer activity picked up with the Greek debt crisis. Revenue fell 4%, but that was largely down to the closure of six satellite trading offices in the US during the second half of 2010.

Profits were marginally lower at £73m. Revenues fell in Europe and the US but rose strongly in Asia. The newly introduced information sales and risk management services businesses also saw strong revenue growth. The firm continues to generate big cash flows, and had £20m of net cash at the end of June.

The biggest challenge for Tullett Prebon has been to rebuild its US business after a raid on its staff by rival BGC in late 2009. The raid affected the European and Asian businesses, too, but the US operation was hardest hit. Operating profit nearly halved there last year. The company took legal action against BGC and some former Tullett Prebon brokers in the UK, US, Hong Kong and Singapore. The London case was settled on undisclosed terms. Broker headcount in the US is now back to pre-raid levels and there have been management changes too - all of which augurs well for the second half of the year.

Tullett Prebon is an attractive income stock, yielding 4.4% at the current price. With an ongoing recovery in the US and growth prospects in Asia and Latin America, that provides solid support while the market waits for the next bout of takeover talk.