Singapore Exchange Ltd (SGX SP) - Maybank Kim Eng 2017-12-20: Part 2 ~ Structural Issues Loom

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Continued from: Singapore Exchange Ltd (SGX SP) - Maybank Kim Eng 2017-12-20: Part 1 ~ Riding On Cyclical Upturn

SINGAPORE EXCHANGE LIMITED S68.SI

Singapore Exchange Ltd (SGX SP) - Initiation Coverage Report Part 2

STRUCTURAL ISSUES LOOM

• This section highlights some of the structural issues faced by SGX, especially for its equities business. 
• Concerns include decline in turnover velocity, low valuations of companies and an inability to attract bigger IPO listings. There is also a loss of retail confidence for the equities business since the penny stock rout back in Oct 2013. 
• For both equities and derivatives, clearing fees and fee per contract are clearly on a downtrend.
• Results from past initiatives have been mixed, for instance the reduction of board lot size for securities listed on SGX from 1,000 to 100 shares (introduced in Jan 2015) did not lift retail participation meaningfully.
• On the other hand, introduction of MMLP Programme in Jun 2014 helped to improve overall liquidity, with MMLP contributing 18-19% of SDAV in FY16- 17.

LACKLUSTRE EQUITIES BUSINESS

Turnover velocity on downtrend; market cap struggled to see substantial growth 

• Turnover velocity (total traded value relative to the average market capitalisation) has been trending down across regional exchanges over the past 10 years. By our estimation, overall turnover velocity declined from ~49% in FY11 to ~27-29% between FY14-17. The decline in velocity can be attributed to lower traded value from lower market activities, coupled with a lack of substantial growth in market capitalisation.
• SGX’s equity market capitalisation grew at c4% CAGR between FY12-17. However, its market capitalisation has been lagging behind its Asia Pacific peers such as Hong Kong Exchange (HKEx) and Australian Securities Exchange (ASX). HKEx’s market cap is close to 5x higher than SGX. The drag on market capitalisation for SGX resulted from more delistings and privatisations that took place in recent years.
• With average market capitalisation forecast to achieve a 3-year CAGR of c6.5%, and higher traded value, turnover velocity is expected to be largely stable between ~27-29% across FY18-20E.

More delistings in recent years 

• Delistings and privatisations in recent years highlighted SGX’s structural problems of low valuations and low traded value. The number of listed securities on SGX decreased by 31 from FY10 to FYTD18. The number of delistings also outpaced IPOs in five of the past eight years, with FY17 being the worst with 29 delistings vs 17 IPOs. Generally, the number of IPOs has been on a downward trend since FY10.
• We think SGX has not been able to attract new and large IPO listings in the past few years due to: 
  1. lower trading volumes on SGX deterred companies to list in Singapore; 
  2. higher listing and administrative costs. SGX raised initial and annual listing fees for SGX Mainboard companies in Jul 2013, with initial listing fees raised from a minimum of SGD50k to SGD100k and annual listing fees from a minimum of SGD25k to SGD35k; 
  3. low valuations as companies found their listings not worth keeping, which also made them potential privatisation targets. Based on Bloomberg data which we screened for each fiscal year, 53% of companies on SGX had P/BV valuations of less 1 in FY16 vs 35% of companies on HKEx;
  4. companies can raise capital from private equity funds.
• Singapore-based companies have chosen to list elsewhere than on SGX. These companies include Razer and Sea (previously known as Garena) which raised capital on HKEx and New York Stock Exchange respectively.
• After declining for three straight years, net market cap of IPOs and delistings for FYTD18 turned positive for the first time at SGD5b. This was supported by larger REITs and business trust listings. While this further affirms SGX’s strong position in attracting such listings in Singapore, Netlink NBN Trust’s market cap of SGD3.13b alone formed close to 50% of total IPO market cap for FYTD18.
• Recent initiatives that can potentially translate to more listing opportunities include:
  1. collaborative listings agreement with Nasdaq in attracting corporates for a concurrent or sequential listing on both exchanges;
  2. collaborating with various government agencies such as Infocomm Media Development Authority (IMDA) and Agency for Science, Technology and Research (A*STAR) to provide start-ups/SMEs with access to capital markets. 
  Consistent with its listing proposition in promoting niche industries such as technology and healthcare, this can create pathways for start-ups or fast-growing companies to leverage SGX for capital access. However, it will take time to see material impact.
• Market capitalisation as a percentage of GDP has been high for Singapore. At 216% in 2016, this implies that Singapore’s capital market could be outsized compared to the scale of the economy.

Clearing fees expected to trend lower 

• Effective clearing fees (two-way of buy and sell trades) have been on the downtrend since FY14, where the reduction each year between FY14-17 has been significant, at close to 16-20bps YoY. This could be attributed to: 
  1. reduction in clearing fees from 0.04% to 0.0325% of contract value since implementation in Jun 2014 to improve liquidity and retail participation; 
  2. Introduction of MMLP to bring in liquidity and improve depth of market in Jun 2014. Currently, fee rebates are also offered to MMLP to incentivize them to trade; 
  3. higher mix of lower-yielding structured warrants, ETFs and DLCs (daily leveraged certificates) in recent quarters, where SDAV for these products has increased from 3% of total SDAV in FY14 to 8% in 1Q18; 
• Moreover, proliferation of alternative products such as ETFs will push down clearing fees. 
• We expect effective clearing fees to decline by 6- 10bps YoY (FY17: 5.64bps, i.e. average clearing fees at 2.82bps) to 5.54bps/5.48bps/5.42bps for FY18/19/20E.

DERIVATIVES MAY SEE SOME PRESSURE

Concentration risk for derivatives products but SGX is improving mix 

• SGX faces concentration risk for its derivatives business, with equity derivatives driving the most volume. As at FYTD18, 80% of total derivatives volume came from equity derivatives, followed by commodities at 10%, and FX/ Others at 10%.
• That said, the volume mix has improved from FY17, where volumes from equity derivatives/ commodities/ FX and Others were 85%/ 11%/ 4% respectively. By also focussing on FX futures, we see this as a positive sign that SGX is diversifying its volume and revenue mix away from equity derivatives.
• The major equity derivative contracts that are most actively traded:
  1. SGX FTSE China A50 Index Futures;
  2. Japan Nikkei 225 Index Futures;
  3. Nifty 50 Index Futures;
  4. MSCI Singapore Index Futures and
  5. MSCI Taiwan Index Futures. 
• As of FYTD18, these five contracts alone made up over 95% of equity derivative volumes, implying that more diversification of products is required to drive the growth momentum of this segment.
• SGX’s FTSE China A50 futures contract, which tracks the country’s 50 largest blue-chips, is the only index that allows investors to access Chinese shares outside China. Volume of SGX FTSE China A50 contracts is positively correlated to the performance of the Shanghai Stock Exchange Composite Index (SHCOMP) and Shenzhen Stock Exchange Composite Index (SZCOMP).
• The same goes for FX and commodities. As of FYTD18, 78% of FX futures volume on average is driven by INR/USD futures, while iron ore continued to drive the bulk of commodities volume. SGX continued to retain its market share of 96% in the offshore market for iron ore derivatives in 1Q18, an increase from 92% and 94% in FY16 and FY17 respectively.

Derivatives’ fee per contract to come down 

• SGX’s derivatives’ blended average fee per contract has been declining over the years from SGD1.43 in FY14 to SGD1.13 in 1Q18. The decline in average fees can be attributed to increased competition from other exchanges and change in mix of derivatives contracts. For instance, the decline of 9bps YoY to SGD1.19 in FY16 was a result of pricing revisions and incentives for iron ore contracts implemented by SGX in order to defend market share. 
• With SGX’s market share gains from lower-yielding contracts such as China A50 (where its market share rose from 4% in FY16 to 32% in 1Q18) coupled with increasing competition, we believe fees per contract is likely to trend lower in future.

Competition in derivatives space 

• Overlapping of product offerings is common as competitors replicate derivative product offerings. For instance, SGX’s recent foray into FX futures contracts saw the launch of four new FX futures contracts (MYR/SGD, MYR/USD, IDR/USD and PHP/USD contracts). Some of these contracts were already introduced on ICE Futures Singapore.
• The role of exchanges has evolved with technological advances, increasing competition, and overlapping of product lines with other exchanges. We think it is important for SGX to diversify or expand its product offerings to remain competitive. Its wholly-owned subsidiary, Baltic Exchange, is also proposing to develop new indices (for e.g. a new LNG Freight Index), launch an escrow service and develop its post-trade tools.
• In Singapore, ICE launched the second derivative exchange in 2015, with the establishment of ICE Futures Singapore and ICE Clear Singapore, partly thanks to its acquisition of SMX. 
• New entrants such as China-backed Asia Pacific Exchange (Apex) have received an in-principle approval from the Monetary Authority of Singapore to be the third derivatives exchange in Singapore, with a focus on refined palm oil contracts. We do not think SGX will be under competitive pressure for now as its main focus is not on CPO futures. However, competitive pressure will intensify if Apex extends its product suite and gains market share from SGX in other products.

INITIATIVES THAT ADDRESS STRUCTURAL CHALLENGES NEED TIME

• Several initiatives to improve its businesses have been roll out under CEO Loh Boon Chye since Jul 2015. These include a focus on fixed income, index business, improved access to retail investors, and niche listing strategy. 
• While management is taking the right direction to diversify revenues and create a vibrant market, it will take time for material impact to be seen.

TRANSFORMATIONAL ACQUISITIONS DIFFICULT

• Transformational acquisitions such as acquisition of another national or global exchange will be difficult. Exchanges are of national importance and such mergers are politically sensitive. In 2010, the failed attempt of SGX to merge its operations with ASX in a takeover bid of USD8b was also another example, which was rejected by the Australian government on national interest grounds.
• Competitors have been aggressive in deal-making to drive further growth to foray into new markets and products. In recent years, index businesses were targeted to create synergies across multiple product lines, particularly as investment banks such as Barclays and Citigroup exited their bond-index businesses.

POTENTIAL GROWTH IN INDEX BUSINESS

• Potential acquisitions or partnerships are likely to be complementary to SGX’s businesses in the areas of intellectual property and customer base.
• We think acquisitions or partnerships are more likely in the areas such as data providers, indices, and trading analytics platforms. This will enable SGX to be a one-stop provider to serve customers throughout the entire process.
• The index business allows SGX to generate recurring subscription fees and also license fee charges when clients use the indices for index-linked investment products (such as ETFs), for passively-managed funds and/or for futures and options contracts.
• SGX’s intention to build and grow the index business is clear from recent product launches by SGX Index Edge (SGX’s index business). SGX is keen to develop new innovative products for investors either on their own or through partnerships and collaborations.

FORECASTS & ASSUMPTIONS

REVENUE TO REMAIN STABLE

• We assume operating revenue will increase by 3-7% YoY and operating profit margin will remain stable at c50% for FY18-20E.

EQFI revenues and sensitivity analysis of SDAV 

• Within the EQFI business, the bulk of revenue is driven by securities trading and clearing, which formed c51% of EQFI revenues in FY17. This was followed by post-trade services at c29% and issuer services at c21%.
• We expect EQFI revenues to post a 3-year CAGR of c4%. For securities clearing revenue, our estimation of 3-year CAGR of 2.5% is premised on the back of higher SDAV levels, but to be offset by lower clearing fees as we believe fee compression will persist.
• Based on our assumption of FY18E’s turnover velocity of c29% and average market cap of SGD1.05t, we derive FY18E estimate of SDAV levels at SGD1.22b. This is higher than FYTD’s SGD1.18b, as we expect stronger SDAV in a cyclical upturn for the rest of FY18E.
• Using our FY18E estimate of SDAV levels at SGD1.22b and effective clearing fees of 0.0554% as our base case scenario, clearing revenues would be ~SGD170m. We tested a sensitivity analysis on the impact of securities clearing revenues for every 10% increase/ decrease in SDAV and effective clearing fees increase/decrease by 0.005%. This is shown in Fig 39.
• Our sensitivity analysis shows that for every 10% increase/decrease in SDAV, clearing revenues will rise by 8-10% or fall by 10-14%, ceteris paribus. While for every 0.005% increase/decrease in clearing fees alone, clearing revenues will rise by 8-9% or fall by 9-11%, ceteris paribus.

Derivatives’ revenues and sensitivity analysis of DDAV 

• The main bulk of derivatives revenue comes from the equity and commodities segment. We estimate derivatives revenue will post 3-year CAGR of c6% vs EQFI revenue of c4%, and will contribute 38-39% of total revenues from FY18-20E.
• We expect fees per contract for FY18-20E to decline by SGD0.30-0.40 from FY17’s level of SGD1.18 per contract, which implies reduction of fees by c3% YoY. To offset decline in pricing, SGX is more likely to drive volumes to increase revenue. With 79m derivatives contracts as of FYTD18, this forms 42% of our FY18E estimate of 187m contracts, and on track to meet our expectations. This implies that we are expecting DDAV of ~735k contracts for the rest of FY18E. 
• We expect DDAV to post a 3-year CAGR of c10%. Assuming our FY18E estimate of 743k contracts for DDAV and average fee per contract of SGD1.14 as our base case scenario, this translates to derivatives revenue for equities and commodities of SGD213m.
• From our analysis, for every 10% increase/decrease in DDAV, derivatives’ equities and commodities revenues will rise by 8-10% or fall by 10-14%, ceteris paribus. While for every SGD0.03 increase/decrease in average fee per derivative contract alone, equities and commodities revenues will rise/fall by 3%, ceteris paribus.

COSTS

• SGX’s cost rationalization has shown improvement through efforts in reducing discretionary expenses. Operating expenses in FY17 fell 2.4% YoY, while 1Q18 +5% YoY on higher staff costs from consolidation of Baltic Exchange.
• Management guided FY18E operating expenses of SGD425-435m, implying a 7-9% YoY increase from FY17. 
• We expect costs to post a 3-year CAGR of 5% and estimate technology-related expenses will post 3-year CAGR of 6%, on the back of higher system maintenance and depreciation expenses from implementation and upgrading of new/existing systems. 
• We expect FY18-20E cost-income ratio to remain largely stable at c50%, supported by higher revenues.

HEALTHY BALANCE SHEET & CASHFLOWS

• As at FY17, SGX had a net cash position of SGD520m (which excludes cash committed for derivatives clearing fund, securities clearing fund and National Electricity Market of Singapore) and zero debt. With its healthy balance sheet and strong cash position, this can help fund acquisitions that can complement its products and business. We expect operating cash flows to remain healthy from improved earnings.
• SGX’s formal dividend policy is to payout at least 80% or 20 cents per share, whichever is higher. We believe it will have ample FCF to fund its dividends. From FY18-20E onwards, we expect SGX to payout at least 80% and project DPS of SGD0.29-0.31 per share.
• SGX is more likely to invest in technological capabilities and platforms to stay ahead. We expect FY18E capex to be SGD65m (upper range of management guidance of SGD60-65m), and capex in FY19-20E to rise by c11% YoY to SGD72-80m.

VALUATION & TARGET PRICE

Initiate BUY with TP of SGD8.30 

• SGX trades at 21.7x FY18E P/E and 20.6x for FY19E. These represent discounts to its regional Asia Pacific peers’ of 36.6x and 32.3x. SGX’s valuations are cheaper than most of its Asian peers, yet it generates higher ROEs of c34-35% for FY18-19E.
• Our TP of SGD8.30 is based on 23x FY19E EPS, in line with its mean since 2012. We think it is justifiable to use a shorter P/E band history as SGX has been trading sideways at ~21-27x since 2012. We think valuations will revert back to the mean from upside in the cyclical upturn. 
• A cross-check with DDM method also suggests that the DDM TP of SGD8.10 is close to our TP (ROE: 33.6%, COE: 7.7%, growth rate: 3%). 
• Our TP has not included any future potential M&As. Dividend yield of c4% (vs 10-year SGS yield of 2%) provides support to our BUY recommendation.

RISKS

Lower SDAV and DDAV levels 

• Market activities have picked up amid a stronger economic outlook and positive market sentiment. That said, SGX is susceptible to risk-off market sentiment, which can result in a decline in market activities and lower SDAV. 
• Lower DDAV levels than our forecast could also be a risk. Our sensitivity analysis is shown in Fig 39 and 40.

Significant regulatory changes and potential disruptors 

• Landscape for global exchanges continues to evolve with new regulatory and compliance rules. For instance, the upcoming rule on MiFID II may require SGX to potentially innovate itself ahead of the curve through investments in trading technology to incorporate MiFID II transparency requirements.
• While SGX is a quasi-monopoly and has relatively high barriers to entry, new technologies and/or new FinTech competitors may potentially disrupt the relevance of SGX’s platform, which will require SGX to constantly keep up with technological advances.

Competition 

• SGX faces strong competition from other regional and global bourses as well as other new entrants. Increasingly, there will be a need to create new and/or enhanced products to retain and attract customers.

Capital raising to fund large acquisitions 

• Given its limited resources and cash balance of SGD520m as at FY17 (excludes cash commitments of SGD274m), any sizeable acquisition of more than SGD1b will require SGX to undertake a combination of debt and rights issue. This can potentially dilute ROE from capital raising efforts.

Ng Li Hiang Maybank Kim Eng | http://www.maybank-ke.com.sg/ 2017-12-20

Maybank Kim Eng SGX Stock Analyst Report BUY Initiate BUY 8.30 Same 8.30