This post is a follow-up to an article I posted on beyondproxy.com on MCX last October. You can read the original article here. Before I went public with my view on MCX, I had recommended the stock to my Premium Access subscribers on September 1, 2013. Since my original recommendation the shares have produced a total return (including dividends) of 112% using Tuesday’s (12/08/2014) closing price of INR 812.20.
From my perspective the easy money has already been made. While most investors hemmed and hawed and failed to make a decisive call, the shares have been steadily rising. In addition, I just got an e-mail from my broker stating that MCX was now a “Buy”. To the contrarian in me, that’s a clear signal that a valuation gap no longer exists. Also, I would argue that his track record is virtually perfect at “top-ticking” stocks. Based on the recent price performance of MCX, his record remains unblemished. Joking aside, I think it’s hard to claim that MCX remains undervalued at current levels.
Before I make my case, I need to give you a little background information. MCX (Multi Commodities Exchange) is the largest listed commodities exchange in India. Its largest share holder was FTIL (Financial Technologies India Limited), with a 26% stake. FTIL is promoted by Jignesh Shah (fortunately there is no relation to your author). FTIL is a 99.9% owner of the crisis ridden National Spot Exchange (NSEL) and is now being forced to restructure its holdings and divest its stake in MCX. If you want more background information, you can read my overview of the crisis by clicking here.
If you’ve been following the crisis closely, you’ll know that there have been more twist and turns in this sordid drama than in a typical Indian soap opera. Fortunately, our story like a serial that has gone on long past its expiry date appears to finally be coming to a close. On Friday (June 13, 2014) the Bombay High Court allowed MCX to continue forward with its plan to amend its articles of association. The amendment to the articles of association allowed MCX to move FTIL’s shares into a special escrow account and provide the authority to sell them. Implementation of the amendment was dependent upon shareholder approval. On Wednesday (June 18, 2014) MCX revealed that shareholders had approved the amendment. FTIL had been dragging its feet in the stake sale process, despite interest and firm bids from both domestic and international buyers.
It appears that the moves made by MCX finally prodded FTIL into action. On July 8, 2014 billionaire investor Rakesh Jhunjhunwala bought 2% of MCX from FTIL via a bulk deal. Subsequently, on July 20 it was announced that Kotak Mahindra Bank had bougth a 15% stake in MCX from FTIL for INR 459 crore. FTIL has also sold part of its stake through open market operations and is now reported to have a 5% stake remaining.
As usual with MCX, there is still a scent of controversy in the air. The BSE (Bombay Stock Exchange) is now openly questioning whether FTIL shareholders got a fair deal. Shouldn’t it be the concern of FTIL’s management and shareholder’s whether they got a fair price and not the BSE’s? Additionally, there is a clear conflict of interest as the BSE was also a corporate bidder for the MCX stake. Other than being a classic example of regulatory overreach by the exchange, I think it’s a baseless case.
From my perspective you need to answer two simple questions, to determine whether MCX is still a “buying” opportunity. First, is the underlying business stabilizing? Second, is there enough upside to justify taking a new position?
MCX Remains the Dominant Commodities Exchange in India Despite the NSEL Scandal
MCX is the dominant commodities exchange in India. Its business franchise has been tainted and damaged by the NSEL scandal. But it still remains the top exchange in India in terms of daily traded value. Despite a string of management departures including “Rent-A-CEO” Manoj Vaish, an ongoing criminal inquiry of Jignesh Shah and cancellation of all (calendar year) 2015 contracts by the FMC, MCX maintained 84.89% market share in the commodities futures market for FY14. If you still don’t think MCX has a discernible “moat”, not even Warren Buffett himself can save you and your portfolio.
The chart below shows that FY14 average daily turnover was INR 278 bn. As expected FY14 average daily turnover is markedly down from both FY12 and FY13. In the beyondproxy article, I had originally forecasted FY14e average daily turnover would be down (40%) y-o-y to INR 293 bn. So the actual number was even below my estimate. I’m actually surprised that I came within 5% of the actual number, given the amount of uncertainty surrounding the company.
Additionally, something curious also occurred with NCDEX, MCX’s second largest competitor. NCDEX’s average daily turnover has also declined in comparison to both FY12 and FY13. Most investors were assuming that NCDEX would pick up market share following the NSEL scandal. Clearly, MCX continues to dominate the commodities futures market in India.
If traders were leaving MCX and switching to NCDEX, you would expect to see an increase in average daily turnover. We can see that this is not happening. In my view, the decline in average daily turnover is due largely in part to the Commodities Transaction Tax (CTT) as I discussed in my original post on MCX. Additionally, ICEX (the Indian Commodity Exchange), which is jointly owned by Reliance Capital and Indiabulls is being shut down due to poor performance. Although ICEX only had less than 1.0% market share, anytime a competitor goes out of business it’s good for the market share leader, which in this case is MCX.
MCX’s core business isn’t impaired. In fact, the commodities futures market in India is under consolidation as weaker exchanges are shut down. However, at current valuation levels you have to be assuming a recovery in average daily turnover.
The chart below shows that average daily turnover bottomed in Q3FY14 and rebounded in Q4FY14. The average daily turnover for FY15 year-to-date is marginally below that of Q4 FY14 but above Q3 FY14. It appears that a bottom is forming in terms of the average daily turnover trend. To answer my first key question, I think the business is stabilizing. However, there is room for a downside surprise over the short-term. A significant pick-up in average daily turnover will be a major catalyst for positive earnings revisions by sell-side analysts.
MCX Valuation Analysis
The company recently reported Q1 FY15 EPS of INR 4.61. As a result, the shares are currently trading at a 34.3x TTM P/E. Based on trailing earnings its hard to make the argument that the shares are undervalued. Using my FY15e EPS, the shares are trading at a forward P/E multiple of 23.4x. With the Bloomberg consensus EPS for FY15 the shares are trading at 30.8x forward P/E multiple. As you can ascertain, my FY15e EPS is above the consensus. The key assumption in my financial model is that average daily turnover will grow by 10% in FY15.
Although I appreciate the simplicity of using price multiples to value a stock, I still primarily rely on DCF analysis. Aswath Damodaran, a NYU professor and noted valuation expert, has stated the following about valuation techniques:
“If good investors buy businesses, rather than stocks (the Warren Buffett adage), discounted cash flow valuation is the right way to think about what you are getting when you buy an asset.”
Based on a standalone DCF analysis and then adding back the proportional value of its subsidiaries, I get a revised price target of INR 844. With the shares trading in the INR 790 range, there isn’t enough upside to justify starting a new position. However, I’ll warn you that the situation is extremely fluid. I think there is enough uncertainty surrounding FTIL’s divestment to result in a better buying opportunity. I would look to enter a new position if the shares traded below INR 675. I’m still holding on to my existing long position as I think there is still reasonable upside and the possibility volumes improve enough for me to revise my earnings estimates upward.
The main risk with MCX in my view is if the Kotak stake sale is held up for regulatory reasons. The FMC has already mandated that FTIL must divest its 26% stake in MCX. The FMC is also preventing MCX from issuing any new futures contracts for calendar year 2015 until FTIL reduces its stake. I’m still unclear why the FMC is penalizing MCX for FTIL failing to sell its stake. Prior to the amendment of the Articles of Association there really wasn’t much MCX could do to force FTIL to sell its stake. It’s like a parent constantly scolding their eldest child when in fact it’s the younger child who is the troublemaker. Basically, MCX is the regulated entity and the FMC really doesn’t have any jurisdiction over FTIL. I think the risk of the Kotak stake sale falling through is minimal. In a worst case scenario, Kotak could simply buy the shares in the open market vs a negotiated transaction.
The company has also been mandated to divest its stake in MCX-SX (MCX Stock Exchange) and MCX-SX CCL (MCX-SX Clearing Coporation) by SEBI. In my view, MCX-SX is a marginal business. If you look at equity exchanges in the US the advent of dark pools has resulted in almost 40% of all stock trades happening “off exchange.” Although we may never see such high levels of “off-exchange” volume due to regulatory reasons in India, the global trend is clear. In my analysis, I’m only ascribing book value to MCX-SX and MCX-SX CCL. I view MCX’s holdings in both entities as an option. In a best case scenario, MCX is allowed to retain its stake in MCX-SX. If MCX-SX is successful, your option pays-off. In a worst-case MCX would be forced to divest and the option would essentially expire worthless.
MCX Investment Summary
MCX has an excellent business that was temporarily damaged due to the imposition of the CTT and fallout from the NSEL scandal. Despite the onslaught of bad news, the company has maintained 84.9% market share in India’s commodities futures markets. Clearly, the company has a “moat” and unseating it from its market leading position will be difficult. Unfortunately, the stock is now priced in accordance with its improving fundamentals and limited possibility of negative repercussions from the NSEL scandal. The shares have rallied significantly from the lows experienced immediately in the aftermath of the NSEL crisis. As I’ve seen time and time again, uncertainty and opacity are always your friends when it comes to value investing. There is still a high probability for future price corrections due to delays in the Kotak stake sale. However, there is no guarantee that a better buying opportunity will eventually materialize. In my view, the only case that can be made that the stock is still undervalued would be in the event average daily turnover picks up materially from Q1 FY15 levels.
Disclosure: I have a long position in MCX. Despite all efforts made to be objective in my analysis, it’s fair to assume that my assessment is somewhat biased.
Read Part 1 of my analysis here.