MCX and Financial Technologies

Stock Opportunities Untested - but worth a good look
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thanks everyone for the well-intentioned views. I have decided to wait it out a bit, maybe read and re-read some books on investing, etc in the meantime. I had done extensive homework to see if there is a possibility of MCX involved in similar mess as NSEL. Apart from some strange patterns in Almond contracts back in 2009-10, I did not notice anything worrying. I am pretty confident, that MCX is not involved in illegal financing mess as NSEL. Also note that it is important to waive off delivery/storage charges to run such a financing scam. See the following notice on nsel website for e.g.

http://www.nationalspotexchange.com/NSELUploads/ExchangeCircular/2012/August/893/NSEL-2012-161.pdf

No such strange waivers found by MCX.

Now comes the question of margin of safety. What if NSEL defaults, lets say MCX even shuts down. One of the things that I was banking on was 800cr cash on MCX’s balance sheet, this is about Rs. 160 per share. This is excluding margin amounts from traders and MCX-SX warrants. I have no idea how much MCX-SX is worth, so lets put a 0 there.

Could the cash still be on its books? Very likely I think. Not because promoters are honest, but because FMC regulates MCX. It has 4 nominee directors on the board and has given orders on Aug 6 to MCX to inform FMC before doing any financial transaction, not related to routine business. MCX is one company where promoters are not in total control. If promoters go bust, there are rules where FMC will itself choose/nominate another promoter.

Now, what if the cash was already missing before FMC’s Aug 6 order? This is one thing I am not 100% sure of. Another is that the price is still too high to be safe, given the possibility of FT going bust. Below 200 would be pretty safe, provided the cash is there. Also the 400,000 terminals/connections which give MCX its 90%+ market share must be of some value for sure.

Whether the promoters already siphoned the cash before Aug 6 will be clear after Q2 results only. Probably I should wait a bit. In any case, the price is too high to take care of the worst case scenario.

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There is very few things in india which truely can be called world class and it is not easy to create world class platforms (MCX is one such platform). We need to give credit to promoters and managements for creating a world class platform for metal trading in short span of time even in country like india against all odds and because of some issues/crisis whole credit cannot be taken away over night. Running any business in complex country like india this kind of problems can come but this does not stop related companies from creating wealth for shareholders. There is hardly any business group in india which can be called completely honest or ethical because it is not possible for anybody in india to do business honestly (even for small task like getting passport, confriming train tickets, registering or renting house etc most of us has to pay some bribe publically and this is well known facts).

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Financial crisis of 2008 and investigations by many agencies revealed how these so called financial regulators, exchanges, financial service providers, investment bankers, stock brokers etc work in reality even in advanced market like US. In normal course by fudging some warehouse materials and inventories, seller of commodities more likely to get benefited than promoters of exchange because most likely exchange can only receive transaction fees and underlying materials belong to buyers/sellers. Few months back similar issues has happened of flash crash in NSE by Emkay Global (broker) due to huge short selling and no body blamed NSE for the same and even penalty for this was levied on broker itself. So in this kind of issues apart from promoters , govt, regulatory bodies and regulations also equally to be blamed.

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Allegations against NSEL Board Members by FMC are serious. Gives a good overview on the lack of / deliberate tampering of Management controls and the gaming of the system. More details are at http://www.bseindia.com/xml-data/corpfiling/AttachHis/Multi_Commodity_Exchange_of_India_Ltd_181213.pdf

Includes

  1. Deliberate misdeeds on part of promoters including flawed internal controls, nefarious associations, deliberate concessions for some companies

  2. wilful violation of laws / their own byelaws and regulatory mechanisms

  3. misuse of Margin money and Settlement Guarantee Fund (SGF) (interesting to note the quantum of SGF funds has been variedly quoted between 62 crores to 850+ crores)

  4. elaborate gaming around Warehouse receipts … building bubbles with non-existent inventory

  5. related party transactions including ABMA (subsidiary of NSEL) becoming client of MCX

  6. and numerous instances of misleading information / deliberate coverups / technicalities to cover up etc.

The document in itself is so scary and how scams are perpetrated by so called poster boys over years, with willful connivance of many other stakeholders. Hindsights in NSEL may make it easier to point out what could have been done to detect earlier, feel we should assess MCX on similar parameters. While MCX is independent, it had a shared past and not sure if there are similar tell tale signs that exists.

I will try to summarize the issues in few bullets tomorrow. How can we analyze / validate MCX ?

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MCX suffered large collateral damage in the market due to NSEL event as it has common promoter FT. However, there is no tangible damage to MCX because of NSEL case. Also, there is no related party transaction/relationship with NSEL. So no liabilities arising for MCX.

  • While the issue at NSEL raised questions on corporate governance; now that the current mgmt. is deemed unfit to operate MCX by the Regulator, I think the corporate governance issue should subside. New MD Mr Vaish was an executive director of the BSE between 1998 and 2004 and CEO of financial services research firm Dun & Bradstreet.

  • Though, the volumes on MCX has gone down drastically in last 6 months, but that is due to various other factors such as increase in CTT, restricting trading of some commodities on exchange, change in trading hours, rising equity markets etc which have no relevance with NSEL event.

  • From FY 15 onwards the CTT impact would be in the base. There are possible regulatory tailwinds in terms of allowing Options, new commodity classes and FIIâs/Banks participation which can increase the business opportunity in a big way. Globally Derivative/Physical trade ratio is much higher than in India (~10x).

  • MCX still looks a Quality franchise trapped in ST event based uncertainty (and hence cheap) but intact LT potential. Over next year as more regulatory clarity emerges and business improves, I think stock can see a good run (Fell from Rs 1600 to 800 due to CTT impact, then to Rs 250 due to NSEL issue an now back to Rs 520).

  • Some Institutions have shown interest in taking the stake (Bombay Bullion Association, United stock ex). If an institution like HDFC/Kotak decides to take the majority stake in the co, it would be looked upon as a big positive.

Now in short term it’s difficult to predict how the stock behaves but from global experience, exchanges who are market leader have a strong network effect moat. Mcx with 85% kind of market share should do very well from medium to LT perspective.

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66

I am completely in agreement with Rohit. A dominant exchange is a wonderful business to own as it is both a combination of moat and :float". As many of us know, it is a “winner takes all” business. MCX has been suffering collateral damage as Rohit mentioned, however, one must be courageous to buy when there is blood on the street. Of course, you shouldn’t throw caution to the wind. We should understand what all risks are involved in buying in a business facing “uncertainty”.I have been trying to understand the dynamics of NSEL scam, reasons for the same, likelihood of its impact on MCX, scenario post actions taken by FMC, MCX’s business and risk-reward in current situations.

I am getting more and more conviction on following things

  1. it has all the characteristics of a wonderful business; asset light model, high return on capital, high FCF, high operating leverage, strong moat, large opportunity size and some “float”. It is a business which falls into A+ category where a small nudge/tail wind (such as FCRA amendment bill) can give disproportionate returns.

  2. There is adequate margin of safety due to its stake in MCX-SX and Dubai gold exchange. DGCX stake even if valued around the same price as that of 2007 (when FT sold 1% stake at USD 12.5 million) will mean around 300 crores value for MCX (3.75%). Similarly, MCX-SX stake + warrants will also have value far higher than its book value (Book value of 120+ crores). In addition company has 800-900 crore of cash (after substracting settlement guarantee fund and investor protection fund). All put together, investment + cash, it self will be worth 1500 crore (I am being conservative here). So, MCX business, is available at 1000-1500 crores on income of 230 crore (from operations). Even if one takes into account volume dip of 30% and similar drop in profit, one is hardly paying 6-9 times FY 14 earnings. This is indeed cheap considering quality of business.

It is an interesting opportunity to cash in on uncertainty to buy a high quality business on favourable term

Discl: I am invested in MCX from 425 levels.

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67

Dhanwil,

The one thing I do not follow from your post is - the dip in profit is 30%; The Sep quarter shows a dip of 66% in net profits. I do not understand the source of such a vast profit dip, but I were to (dumbly) extrapolate this, then profit generation is ~110 Cr, and that translates to 12-18 times FY14 earnings. The pricing seems reasonable then.

The key issue for me in this story are the following:

(1) What would be the FY 14 & FY 15 earnings, without any changes in operating conditions?

(2) The value of the assets are unlikely to be unlocked within the next 2-3 years. The longer it takes, the lesser is an investors IRR. This is important since every 3 years, we apply a discount rate of 2x here at valuepickr, much larger than the market.

On the positive side:

The sales growth rate in the absence of other triggers is around 25%/year - which is great, and adding a 5% dividend yield, is highly impressive. This alone would ensure we don’t lose money in the long run as long as the price paid is not exorbitant.

The real question now is if I am paying 20+ PE or something much lower, not expecting the asset unlocking to play out.

Thanks,

-Prasanna

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Attaching Kiran’s analysis as well - Pretty similar. He expects 125 Cr as net profit, base case.

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Hi Prasanna,

The way I am looking at the company (and that is how I typically look at most of the companies) is what will be this business worth to a private owner? In that context, when MCX decides to sell the business or part of business to private owner, how the private owner value DGCX and MCX -SX stake is what will matter. So, whether value unlocking will happen in next 2-3 years or not is not he focal issue as I believe this cash + investment (assets) provide some down side protection to the company in terms of valuations. Having said that, MCX-SX warrants (which constitutes 30% equity stake equivalent of investment in MCX-SX) need to be transferred/sold to non-promoters by June 2015, according to high court judgement and hence, value unlocking in MCX-SX to that extent will happen by June, 2015. For DGCX Stake sale, timing can be anybody’s guess. However, if RBI directive on not having stake in exchanges where Indian currency derivatives are traded is to be implemented, MCX may have to look for disposing of its stake in DGCX sooner than later. However,here there is no certainty on timeline.

One of the reasons for vast profit dip is naturally operating leverage! So when we glorify operating leverage we must also understand that It’s a double edged sword. Hence, if revenue drops by 30%, operating cost largely remain unchanged (as it’s largely fixed) hence the drop in bottom line is more drastic. However, personally, I feel that extrapolating this number is playing ultra-conservative. I also agree that profit estimates for FY 14 shall be in line with yours/Kiran’s estimate of 120-140 crores depending upon how volumes pick up in last quarter. However,for FY 15 if one is looking at 25-30% increase in volume from a low base, it can end up with bottom line of 170 -180 crores in FY 15. If we analyze the 5 year/10 year volume history of world’s leading exchanges (CME/ICE) they have also experienced volume dip ranging from 15-30% in few years and have bounced back in subsequent years. So, I believe, with Indian economy getting more integrated with world economy commodity derivatives volume eventually will catch up and far surpass FY 12’s volumes in next 5 years.

Without getting anchored on to P/E numbers, here is what my valuation-investment rationale. Broadly, what I am paying for MCX as private owner for “operating business”, after deducting for cash and investments, is 1200 -1300 crores (2700 crores market cap -1500 crores of cash + investments). Now on a operating revenue of 120-170 crores, it looks very attractive, especially considering lot of possibility of tailwinds/upsides moving forward and very high quality of business.

So, it’s a situation where downside seems to be limited while one is getting exposed to significant upside.

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70

In all this discussion no one has pointed the management angle

Everyone is assuming that MCX runs on autopilot and would remain at the top without active management or product innovation.

It was Jignesh’s (whatever you may think of him post scam) aggressive style that brought leadership status to mcx in commodities business

While projecting numbers one should take into account that mcx would now be operated like a semi govt institution and would lack the energy it used to exhibit in its hay days.

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Hi Excel,

I think, your point is very valid. All said and done, JS’s dynamic attitude and his penchant for product innovation and creating new markets was surely very important in taking MCX where it is today. So it’s important to monitor how the new management takes this up going forward as market leadership is definitely not a given especially when other players are looking at every opportunity to take away market share from you. But, my gut feel is that if there is decent management, MCX can do reasonably well in terms of scaling up business. My reasons are as below

)- A large stake in MCX is held by many FI/FIIs of repute which would want to have a management in place which performs and delivers

)- Dr. Manoj Vaish is considered a very competent person and was instrumental in introducing many new initiatives during his tenure at BSE. With him at the helm, the comfort level is slightly higher.

)- Thirdly, the broad tenet here is that pie is going to be much larger in next decade if provisions in FCRA amendment bill gets implemented and even with reduction in the size of the slice (market share), in absolute term the business scale will be much higher.

However, I do not think assuming MCX to operate as semi government company is appropriate, just because FTIL is not there. First of all, FTIL stake will be sold to some other anchor investor who will be as interested in growing business as FTIL. I think, your inference on “semi government style” comes because of the large stake held by some PSU Banks and government backed FIs. However, this generalization may not be appropriate and we don’t have to go too far to see it. Just look at how NSE is performing and scaling up in spite of it being an initiative by government promoted FIs and institutions.

Having said, I agree that an investor should keenly monitor how proactive the new management team is and whether they can bring company back to growth path or not.

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Dhanwil - Solid set of arguments. I read in Sanjay Bakshi’s post on FT/MCX (in the comments) that he does not foresee long term growth at 20%/year - which I don’t quite follow why.

What would a story look like for MCX to triple from current levels in the next 5 years? Since market share is 90+%, growth has to come from market penetration.

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While the valuations for MCX are favourable and the risks with the NSEL fiasco receding, i am not so bullish about the future revenue growth of MCX.

Almost all of the revenue on this exchange is in metals and primarily gold, silver and copper. This should be seen in the backdrop of a very rare commodity supercycle that happened in the last decade. Gold, silver and copper prices are softening and will continue to trend down. Will the trading volume be maintained in the years forward? I don’t think so. The speculators on these commodities will be driven away and only people who need to hedge their physical positions would be left in the market.

Let us see how it unfolds but higher volumes are not a given till the basket of commodities being traded widens and there is true hedging going on as is the case in most of the commodity exchanges worldwide.

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Hi P.Sharma,

I tend to agree with you here that growth is not a given and to a large extent will depend upon how additional commodities gets approval to be traded on the exchange. As munger says, it’s a game odds! So, one has to decide whether odds are in one’s favour or not. In the longer term, I feel there is large potential for number of commodities to be traded on a very large scale on Indian commodity exchanges. Consider this,

We are in the top 5 producer/consumers for cotton, sugar cane, pulses, oil seed, wheat, rice, gold, silver, zinc, steel, oil, coal to just name a few. In terms of consumption/capita and productivity we are still well below average on production/consumption norms by world average. So, if we believe that in next 10 years we will grow at moderate rate, the size of the market will expand only. Hence size of the physical commodity market and trade, the cornerstone of thriving commodity market seems to be in place.

Second point is, are we as a country will move towards more prudent and transparent approach to price discovery and risk management in next decade? I would presume that if we want to move towards next level of reforms, higher integration with world economy and a level playing field to Indian producers, we will eventually do that. However, one has to discount based on one’s conviction(!) in convoluted thinking and agenda of our political class!

In terms of concentration risk, I also had similar concerns until I came across some analysis that many of the leading exchanges in the world like ICE/Nymex and even CME (for individual asset class), top 3-4 commodities contribute to 75% of trading volume on an exchange. And yet, these exchanges have thrived and grown many fold even though the underlying commodities went through their cycles. So, why should we pre empt the outcome especially when the history suggest the otherwise.

Having said all these, being a conservative investor what matters most to me is to protect the loss of capital. As mentioned earlier, I think at current valuation, there seems to be decent protection on the downside while if the hypothesis holds true, exposing one to some significant and consistent upside and part ownership of a very strong business with moat and float both.

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75

Hi Dhwanil,

You have any data as to what the volumes of a commodities exchange are correlated to?

Say more with the economic activity or more with commodity price volatility or price uptrend?

I feel the massive expansion in volumes was more so because of uptrend in gold price

Now that the gold is in a downtrend volumes have come down

Thanks

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Dhwanil,

I don’t disagree with your arguments. However, we all know our political system. We have been waiting from 2002 for fuel price de-control. It hasn’t been achieved as yet. I have the same feeling about agricultural commodities. There will always be a political reason for not doing it. Now coming to the non-agriculturalcommodities, the imposition of CTT was the latest example of the generalmismanagementof the economy. Gaping fiscals holes have to be filled and any extra tax even if it kills the golden goose is game.

The FCR(A) amendment bill 2010 is also hanging fire and the signs of it coming to life anytime soon are remote if not absent.

I don’t think that we can make an argument for MCX on any positive legislative action. If it happens, it is just a bonus.

The opportunity in MCX at the moment is that the market is not able to distinguish between risk and uncertainty.

The risks have to be addressed by valuation. The exchange is available at Rs 2400 crs as of today closing. MCX has around Rs1200 crores in cash and investments. I am including the Rs 128 crores MCX-SX warrants in this with no premium. Therefore the EV is Rs 1200 crores with possibly Rs 200 crs of profits for FY 14. This is a reduction of 33% profit over FY13. The exchange is available at 6 times FY 14 if these numbers are correct. What can we predict for FY 15? I can’t put my finger on it. What is the impact of the NSEL scam on commodities trading vis a vis a general reduction in commodities volatility leading to lower volumes. How much will the two factors impact volumes? Any reduction in volume will have a negative operating leverage impact and will depress profits even further. If we can answer this question convincingly, then a call can be taken.

The uncertainty surrounding MCX is our biggest friend. FTIL holds 26% equity and their presence is leading to a lot of questions. In my opinion, with no board seats and no management control, their presence or absence makes no material difference. They will eventually be asked to reduce their stake to 2% and that will happen in due time. According to my understanding, the NSEL scam has not resulted in any liability on MCX. Even if FTIL goes down, the stake will be unwound in an orderly manner as the Govt. wouldn’t want MCX to go down with it and result in a NSEL like chaos again.

Therefore is we can answer the volume growth/degrowth question we can have a winner on our hands. In the meantime we can sit tight and wait for the valuations to get more attractive.

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Hi folks,

Given the situation this discussion is in, I would like to send you over a particular series of blogpost (looks like it will be a 4 series blogpost) written by a person who goes by the name of StoicStudy.

The links are:

Part 1, Part 2and Part 3

He has talked a lot of the things in detail, including a few scenario analysis and a stress test. Till now, he is yet to come up with the last post in the series. However it is instructive to note his viewpoints as I found it interesting.

I must sound a disclosure here: I know him and he is in my friend circle.

Coming to the matter at hand, I am apprehensive about the huge fall in trading volumes on the comexes. A huge part of this is to be blamed on CTT. As of now, we dont know how this ctt thing is going to pan out and how the comexes will deal with it. But it does no favour to mcx.

Disclosure: Reluctantly long in MCX

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Hi,

I am glad to see lots of thoughts and views from different people about MCX.

I feel Commodity business is an amazing business to be in. The roe and roce’s have always been amazing. More importantly MCX was a market leader with 86% market share before this fiasco.

I feel inclined to support Dhwanil as i am glad that FMC as well as govt seem to be interested in ring fencing MCX from any damages. At this moment i feel most of the negative news have been priced in the stock.

The most important development people should take into consideration is management change. so getting a chance to get your hand in a business with trailing pe of 10,present pe of 20 (taking into consideration last quarters eps) and huge dividend yield with a possibility of getting a new management seem like a great turnaround to investment.

In long term(5 years), just think about how much business a top player in commodity exchange can do in huge country like India.

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Hi Excel,

I do not have any collated data on specific commodity price correlation with volume for other exchanges around the world. However, as I went through ARs of other listed exchanges in the world and trend in their performance over a period, I had following observations.

  1. Within commodities, in last few years, energy commodities (oil/gas) were the most volatile commodities and were one of the largest traded commodities.

  2. Volatility had the largest correlation with the volumes. Hence, I am inclined to infer that volatility is the single most catalyst for higher trading volumes. Moreover, in case of crude oil and gas, even during the down cycles, traded volume remained healthy and even increased.

Increasing gold prices might have contributed to the increase in volumes at MCX but may not be the sole contributing factor.

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80

Hi P.Sharma,

I also have a similar thought process in terms of valuing a company, uncertainty surrounding MCX and short term headwinds in general. I personally feel that for FY 14, NP shall be in the rage of 120-150 crores and very difficult to crystal gaze FY 15 revenues.As there is a complex set of variable playing out for the company (CTT/NSEL/Exit of Anchor investor/New management’s performance/ Declining gold/silver prices) in near future, I am trying to assess the probabilities of following aspects

  1. What is the probability of MCX surviving as exchange for next 10 years given its current status?

  2. How likely it is that the PV of future cash flow will far exceed 1200 crores in next 10 years?

  3. Does it have potential to command market cap of 20-30,000 crore company in next 10 years? If so,how favourably it is placed?

I think by asking this 10,000 ft view kind of question, we can better judge the attractiveness/unattractiveness of MCX as investment opportunity.

I am looking at MCX more as an opportunity to get 10 times return in 10 years instead of a doubler in 3 years.