December 22, 2013
On Wednesday, December 18, 2013 the FMC (Forward Markets Commission) granted approval for US Private Equity firm Blackstone Capital to raise its stake in MCX (NSE:MCX) to 5% from its current 2% stake. As expected shares of MCX have rallied hard. The stock is now up 18% from Tuesday’s closing price, despite the announcement by the FMC that Jignesh Shah, chairman of FTIL (Financial Technologies India Limited) is “unfit” to run an exchange in the country. The ruling also stipulated that FTIL would have to reduce its 26% stake in MCX to 2%.
I originally wrote an article, which was published on October 12, 2013, on MCX for www.beyondproxy.com. In the article, I stated that a forced sale of FTIL’s MCX stake would be a positive catalyst. You can read the full article here. Additionally, the Board of MCX will be meeting on December 26, 2013 to discuss the FMC’s order to reduce FTIL’s stake. If the Board clears the way for a new anchor investor to take FTIL’s place, it would allow MCX to move past the NSEL crisis.
Blackstone is one of the top 5 private equity firms in the world. I’m sure they see the potential in the MCX franchise. It would be inconceivable to me that they would raise their stake without being sure that a new anchor investor will be found. Kotak Mahindra was rumored to be a buyer in August. I’m sure that they are still in the hunt. After reviewing MCX’s Q2 FY14 results, I’m even more confident about the underlying profitability of the business and its ability to weather the NSEL crisis, which happened at an unrelated entity.
Superficially, MCX’s Q2 FY14 results look poor. Revenue was down 36% y-o-y from Q2 FY13 and operating profit was down 68%. However, the Q2 FY14 results included a INR 1,316.79 lakhs charge, which represented 5% of total revenue for H1 FY14. Due to the NSEL scandal, the FMC (Forward Markets Commission) has mandated that the company set aside 5% of gross revenue from FY08 – FY13 to create a settlement guarantee fund (SGF). Even including the SGF charge, the company still reported EBIT margins of 55% in H1 FY14. Now that’s what I call a true business franchise. Most importantly MCX maintained its market share at 89% for total commodities trading in India for H1 FY14. As I mentioned in my article, one of the biggest risks to MCX is the possibility that futures traders switch to an alternate exchange.
The company is clearly maintaining market share, which is a positive signal. I think the decline in revenue was largely due to the impact from the Commodity Transaction Tax (CTT). I think there is more upside in the shares. If you’re interested, I’ve reprinted my beyondproxy article below. In it, I lay out my investment case for MCX.
Disclosure: I own MCX. Although I always try to remain objective in my investment research, it’s fair to assume that I will be biased in its favor.
Originally published on October 12, 2013 at www.beyondproxy.com
Don’t Throw the Baby Out with the Bathwater: A Case for Multi Commodity Exchange (India: MCX)
By Ankur Shah
There is currently an ongoing crisis that began with the National Spot Exchange (NSEL) in India that will have large ramifications for Indian capital markets as a whole. The NSEL a spot commodities exchange and a subsidiary of Financial Technologies (NSE: FINANTECH) suspended all trading in forward contracts on July 31, 2013. The Forward Market Commission (FMC), India’s commodity derivatives regulator, requested that NSEL shut down all trading in forward contracts when it found out that NSEL was offering forward contracts for delivery over a period of 25-36 days. Under current regulations spot forward contracts must have a delivery period of less than 11 days. Additionally, all spot exchanges must ensure that all outstanding positions will result in physical delivery and not allow any short selling.
15% Guaranteed Returns
The NSEL received approval to operate in June, 2007. According to this article from The Hindu Business Line, the exchange struggled to find market participants until it began offering a paired T+2/T+25 product. This product essentially allowed a “lender” to buy a commodity on a T+2 settlement basis and then simultaneously sell the same commodity for a T+25 settlement at a higher price. The person entering the opposite side of the transaction, otherwise known as the “borrower” sold his/her commodity on a T+2 basis received funds upfront and then paid back the funding on a T+25 basis. Eventually this product pairing became so popular that domestic brokerage houses in India began selling this product to their HNI clients as being “risk-free”. According to various presentations made by brokerage companies a “lender” could earn up to 11-15% annualized returns doing this type of transaction. Naturally, my first question is who would be dimwitted enough to take the other side of this trade and pay 11-15% on an annualized basis for financing. I subsequently learned that the current financing rates in certain commodity related sectors are almost equivalent to the rates that were being offered through the T+2/T+25 paired trading scheme. Thus, a “borrower” may have had a valid economic reason to enter into the trade but the “lender” should’ve had enough common sense to realize that no financial instrument offering 11-15% guaranteed returns is “risk-free”.
The problem with the whole scheme occurred when the FMC shut down all futures contracts on the NSEL. This resulted in “lenders” pulling back funds and left “borrowers” on the hook to pay back the funds without rolling over new contracts. However, the “lender” does technically own warehouse receipts for a commodity that he originally bought on a T+2 basis. Theoretically, he should be able to sell this commodity and recoup some of his money. The only problem is that no one really knows whether the actual commodities exist and if they do, what prices a distressed seller would receive.
It’s looking increasingly unlikely that NSEL has the physical inventory to make good on its payments. NSEL has an outstanding liability of INR 5,500 crore (USD 885 mn) due to approximately 13,000 investors. Although the company came up with a post-default payment schedule, it has now defaulted on its 8th straight payment. To make matters worse, Amit Mukherjee became the first NSEL executive to be arrested but probably won’t be the last. In my view, the stock of parent company Financial Technologies is not investable. As an investor you can’t make an accurate determination of the liabilities both financial and regulatory that the company is facing. As a result, any investment in FT is simply speculation and not an investment.
Multi Commodity Exchange and a tangled web of subsidiary relationships
However, as a contrarian, I wouldn’t want to waste a serious crisis without finding a potential investment opportunity. Fortunately, there is in my view one way to play the crisis. Multi Commodity Exchange of India (NSE: MCX), which is India’s largest and only listed commodity exchange has been a victim of collateral damage. Financial Technologies, is the single largest shareholder with a 26% stake in MCX. Although there have been no accusations of wrongdoing targeted at MCX, investors are concerned about the potential exposure from related party transactions and the fallout from the NSEL scandal impacting trading volumes. When valuing Indian companies a major issue is the appropriate valuation and assessment of cross holdings. If you’ve ever looked at any Tata company balance sheet, you’ll know that an investment in one company means a joint-investment in another 20-25 related companies. NYU professor Aswath Damodaran provided a good explanation of why the cross holding corporate structure is so prevalent in India in a post on his popular blog site. He states the following:
“While one reason for this cross holding structure is corporate control – it allows the family to preserve its control of the group companies – there are also more benign reasons, rooted in history. In the decades before the 1990s, Indian investors had little access to financial information from the company, let alone analyst reports or investment analysis. In that period, these investors had to essentially buy companies based on how much they trusted the promoters of the company, and a trusted family name became a proxy for research. In addition, when capital markets are undeveloped, having an internal family group capital market, where excess cash at some companies can be redirected to other companies that need the cash can be a competitive advantage.”
Jignesh Shah (FYI: no relation to the author) who is the founder and main shareholder of Financial Technologies has also created a tangled web of control through his stakes in both the MCX and MCX-SX (India’s third and newest stock exchange).
A Leader in the Indian Commodity Market
I’ll start with focusing on MCX’s core business before dealing with potential liabilities relating to NSEL. There are currently six electronic multi-commodity exchanges recognized by the government of India: MCX, NCDEX, NMCE, ICEX, ACE and UCX. The national exchanges accounted for 99.7% of the turnover of commodity futures contracts trading in India during FY13 (year ending March 31, 2013). If you’re trading commodity derivatives in India, you’re using one of the main national exchanges. Based on company data, MCX maintained a market share of 87.3% in terms of total value traded in the Indian commodity futures markets in FY13.
MCX is by far the dominant player in commodity exchanges in India. NCDEX was a distant second in terms of market share with 9.4% for FY13. MCX primarily earns its income from transaction fees. In the latest fiscal year (FY13), the company earned 75% of its revenue from transaction fees. The company earns approximately .34 bps as a percentage of total turnover. Thus, the key driver of revenue is average daily turnover on the exchange.
In general, I want to find companies that have a sustainable competitive advantage. It’s clear that MCX benefits from a “network effect”. As more buyers and sellers utilize the MCX, the alternative exchanges become less attractive in terms of pricing and liquidity. The question that you need to ask yourself is whether investors will move to another exchange because they no longer trust management or counterparty risk following the NSEL scandal.
Rather than guessing about the potential impact, the MCX actually provides trading data on a daily basis. In the chart below we can see that average daily turnover on the exchange has declined to INR 218 bn in September, 2013. However, there has been in no way a collapse in trading. Given the size of MCX, I don’t think there is a viable alternative. A number of analysts have speculated that the second largest exchange, NCDEX (which is owned by the National Stock Exchange) is growing its market share. However, average daily turnover in both Q1FY14 (quarter ending June, 2013) and September, 2013 has been relatively flat for NCDEX as seen in the chart below.
The other factor driving down average daily turnover was the introduction of a Commodity Transaction Tax (CTT) that was implemented on July 1, 2013. The average daily turnover on the MCX actually declined in July well before the NSEL scandal broke out. Ideally, I would have liked to see a similar decline in turnover for the NCDEX in July to confirm my view that the CTT was the major driver of declining volumes.
However, the FMC recently disclosed that the total combined turnover on Indian commodity exchanges declined by 25% in the first six months of FY14 (year ending March 31, 2014). Thus, the declining volumes on MCX can’t solely be attributable to the NSEL crisis and a loss of faith by traders in the exchange. At a minimum, both the MCX and NCDEX provide turnover data on a daily basis. As a result, it’s relatively straight forward to keep track of the data on a continual basis to verify if turnover for MCX has in fact stabilized.
Getting back to the issue of potential liabilities, it appears that there is no direct link between NSEL and MCX. The FMC has installed R.M. Premkumar, a retired Indian Administrative Service (IAS) officer, as an independent interim chairman of MCX. The board of MCX now has four independent directors that were appointed directly by the FMC. Premkumar himself has stated the following, “there is absolutely no linkages, financial or otherwise with NSEL, which is a totally different company.” Thus, the main fallout from the NSEL crisis for MCX was reputational as opposed to any financial or legal liability.
The following quote by John Dorfman of Thunderstorm Capital in the book The Art of Value Investing, is particularly apt in terms of assessing the outlook for MCX:
“We named our firm Thunderstorm Capital because a thunderstorm is a frightening but temporary event that usually passes without lasting damage. In constructing our portfolios, we try to invest in good companies whose stocks are depressed by frightening but temporary bad news. The trick, of course, is to distinguish thunderstorms from Category-5 hurricanes.”
In the case of MCX, I think we’re facing a particularly severe thunderstorm and not a Category-5 hurricane. I’m valuing MCX on a standalone basis using a DCF model and then adding back the proportional ownership in its subsidiaries. MCX currently has the following proportional ownership in the subsidiaries/associate investments listed below:
- 100% ownership in Multi Commodity Exchange Clearing Corporation Limited (MCXCCL)
- 51% stake in SME Exchange of India Limited
- 26% stake in MCX-SX Clearing Corporation Limited (MCXSX CCL)
- 38% of MCX-SX (India’s newest and third largest stock exchange). MCX owns 5% of the voting rights and the remaining 33% stake consists of warrants. In order to get approval from SEBI (Securities Exchange Board of India) to launch the exchange, Jignesh Shah had to ensure that no shareholder other than financial institutions held more than 5% of the voting rights. Mr. Shah originally owned 70% of MCX-SX. He devised a plan where total voting rights were reduced to 5% but retained significant ownership through warrants.
Excluding MCX-SX, the stakes in the other subsidiaries are immaterial to the overall investment thesis. I’ve simply used reported book value as of FY13 and applied MCX’s proportional ownership. The stake in MCX-SX is in my view an option. Essentially by buying MCX you get an option on MCX-SX for free. The volumes on MCX-SX have been marginal at best since its launch in February, 2013. However, the real potential was not on the equity side but the ability to trade single stock futures and options. I think it’s still too early to tell whether the exchange will be successful. Even the mighty NSE was a start-up in 1994 and eventually surpassed the BSE in terms of volumes and transactions. For now, I’m only valuing MCX-SX on its book value as of FY13. However, there is clearly the possibility that my estimation severely undervalues the asset if it ends up being successful.
On a stand-alone basis FY14 (year ending March 31, 2014) revenue will below that of FY13. I’ve already factored in a (40%) y-o-y decline into my financial model, which results in an average daily turnover forecast of INR 293 bn for FY14e. As a result, I get a forecasted FY14e EPS of INR 24.3. Even with depressed revenue levels the company is still capable of producing an EBITDA margin of 46% in FY14, down from 68% in FY13. I’m also forecasting that revenue doesn’t recover to FY13 levels until FY19 in my DCF analysis, which is highly conservative. Furthermore, the company has no debt and INR 163 per share in net cash (excluding cash held on margin) on the balance sheet. Net cash currently accounts for 38% of total market capitalization.
I have a INR 727 target price for the shares using an 11% cost of equity. The uncertainty surrounding NSEL has marginally impacted volumes on MCX. If you agree that the long-term business isn’t impaired, MCX is attractive at current prices. The shares closed on Thursday October 10, 2013 at INR 425.5. Although I don’t really follow other investment managers, the HDFC Prudence fund also picked up some shares at INR 293.35 on August 10, 2013 according to this article. I highly respect Prashant Jain, HDFC’s CIO, and it’s reassuring that he also sees value in the shares.
No discussion about an undervalued stock would be complete without a view on potential catalysts to get the shares to re-rate. In my view, the main near-term catalysts for the stock are the following:
- Financial Technologies could lose its “fit and proper” status and be forced to divest its entire 26% shareholding. The Kotak Mahindra Group, one of India’s leading financial institutions, has already expressed interest in purchasing the stake. It’s likely a change in ownership would result in a re-rating.
- Management has submitted a proposal to the RBI (Reserve Bank of India) to increase the foreign ownership limit from 23% to 49%. There is increasing interest in the shares from FII (foreign institutional investors). An increase in the foreign ownership level would be a positive catalyst.