Singapore Exchange - Maybank Kim Eng 2020-11-16: A Different Beat; Initiate Coverage With BUY

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SINGAPORE EXCHANGE LIMITED (SGX:S68)

Singapore Exchange - A Different Beat; Initiate Coverage With BUY

SGX is transforming. This offers opportunities.

• Singapore Exchange Ltd (SGX) has evolved from a cash-equities exchange to a pan-Asian, multi-asset platform offering derivatives, fixed income and alternative products. This positions it to benefit from multiple structural trends that are driving demand for risk-management products.
• SGX's balance sheet has the capacity to gear up offering significant dry-powder for accretive, bolt-on acquisitions in growth segments. While SGX’s cash-equities business is ex-growth, it enjoys high operating leverage and contributes to dividend visibility.
• SGX's valuations are un-stretched (trading at mean PE), while offering a highly visible 3.5% yield.
• Initiate coverage on SGX with BUY and target price of S$10.77.

Changing business mix - Right place, right time, right solutions?

• Singapore Exchange (SGX) operates Singapore’s securities exchange as well as a regional derivatives exchange along with support services and infrastructure. It has been evolving from a traditional cash-equities exchange to a broader, multi-asset solution. The Group’s non-cash equities businesses contributed 62% of revenues in FY20 compared to just 38% in FY12. We estimate this to rise to 74% by FY23E, underpinned by higher volumes in SGX’s product suite of index, FX and commodity derivatives. The Group’s derivative market turnover growth has overtaken securities market growth since FY14.
• Indeed, derivative volumes in FY20 reached 3x higher than FY12 levels. Contrastingly, securities volumes have remained flat to slightly below those levels.

Structural drivers increasing demand for Risk Management Solutions

• We believe risk-management-driven derivative volumes should continue to see an upward trajectory, fuelled by several drivers. These include:
  1. Rising market volatility
  2. Stricter regulations
  3. Digitisation of fixed income & OTC
  4. More passive investing
  5. Reconfiguration of supply chains
• These factors should allow for complementary positioning of SGX’s product offerings, in our view. The Group offers a wide array of solutions and risk-management products.
• Even prior to the COVID-19 pandemic, market volatility has been rising rapidly in Asia. This has been due to US-China trade war tensions, geopolitical uncertainty in the South China Sea as well as massive levels of liquidity injections post the Global Financial Crisis (GFC). Low interest rates have also been a contributing factor.
• The advent of COVID-19 and the resultant lockdowns and travel restrictions have further increased uncertainty and lowered market visibility. This is being reflected in the markets regionally, with major indices across Asia (as well as globally) displaying significant volatility year-to-date.
• This volatility is unlikely to wane going forward with economic activity expected to remain under pressure and individual country GDP recovery trajectories taking widely different paths to normalisation.
• As measure of global volatility, we see that the VIX has also been indicating significant turbulence – particularly in 2020. But even if you ignore 2020 as a whole, the past few years have also experienced significant gyrations.

Stricter Regulations

• Following the GFC, there has been significant push towards increasing transparency and stability of the financial system. International standard setting bodies and regulators including the FSB, IOSCO, CPMI and BCBS have been pushing for reforms to encourage centralise clearing and improving information availability.
• Specifically, regulations that are implementing Uncleared Margin Rules are estimated to impact a significant portion of derivative trades from September 2020. These rules will make trading bilateral FX options over-the-counter (OTC) significantly more expensive, according to Greenwich Associates. As a result, more of these trades should get pushed on to exchanges and electronic trading.
• Separately, the US SEC has amended its rules to enhance requirements for more market disclosures and investor protection for OTC derivatives since September 2020.
• In 2019, Singapore’s MAS rolled out amendments to the mandatory OTC derivative trading obligations. Starting from April 2020 this is encouraging more trading to go into organised markets. Increasingly, we believe regulators would continue to favour on-market derivative trading as a means of ensuing better transparency and market stability going forward.

Digitisation of Fixed Income

• The fixed-income market has been traditionally offline and conducted over the counter. According to Vanguard, this is now changing driven by:
  1. Increased regulations for transparency
  2. Dealers reducing bond inventories due to new capital requirements and reduction in resources
  3. Increase in electronic and algo-driven trading
  4. Higher participation of ETFs and target asset allocation funds
• These factors are accelerating growth for on-market fixed income trading. We believe these trends will expand globally, including Asia. This should have a positive impact for fixed income listing and trading platforms such as BondPro offered by SGX. Separately, in September 2020, SGX – together with HSBC and Temasek - completed a digital bond issuance using digital asset technology leveraging smart contracts and distributed ledgers. Issues such as these should support acceleration of on-market, electronic bond transactions further, in our view.
• Separately, subsidies offered by the Monetary Authority of Singapore (MAS) to encourage first time bond issuance in Singapore should be an additional tailwind, we believe. According to its Singapore Corporate Debt Market Development Report 2019, average annual first-time debt issuance doubled in 2017-2019 vs 2014-2016 as a result of the Asian Bond Grant scheme launched in 2017. The MAS’ Sustainable Bond Grant Scheme, which supports ESG-linked debt issuances with subsidies for offsetting external review costs, should also encourage more bond issuances in Singapore, we believe. This scheme is set to run till May 2023.

More Passive Investing

• ETF assets under management are rising rapidly across Asia-Pacific, according to PwC. Indeed, regionally there is an acceleration of innovative ETF launches including products such as smart beta and factor investing. Regional smart beta ETF AUM has tripled since 2013.
• Additionally, there is increasing demand for sustainable investment driven by increasing focus on environmental and climate risks. This should also drive higher product innovation in the region, especially around ETFs. Also rising climate risks are likely to increase market volatility going forward, driving up demand for hedging products, in our view.
• SGX’s acquisition of Scientific Beta – an index development firm established by EDHEC Risk Institute – should support it with a credible pipeline of product offerings in this space over the medium term, we believe.

Reconfiguration of supply chains

• Uncertainty and unpredictability of US-China relations and disruptions experienced due to COVID-19 should accelerate supply chain relocation from North Asia to Southeast Asia, in our view.
• As corporates adopt a China+1 supply chain strategy, Singapore should benefit given its role as an AAA rated global financial centre and host to multiple regional MNC HQs. This should drive up demand from corporate treasuries for risk-management solutions, where SGX’s product suite is complementary, in our view.
• Deep liquidity in these products and a strong execution track record should provide SGX with a competitive advantage vs rival offerings regionally.

SGX is leveraged to benefit from growth drivers

• We believe SGX has built a comprehensive product suite that provides investors with opportunities to manage risks as the operating environment in Asian markets evolve.
• By way of background, in May 2020, SGX discontinued its 23-year licensing agreement with index provider MSCI. At the same time HKEX announced a fresh partnership with MSCI to move its futures and option derivative products to Hong Kong. This has resulted in SGX winding down its MSCI-index linked futures contracts with a target of fully exiting by February 2021. The exception is the MSCI Singapore contract, which will remain listed in Singapore.
• In August 2020, SGX signed a strategic partnership with FTSE Russell and has accelerated migration of its MSCI Index products to the new partnership. In our view, this background of major change and migrations offers a clear opportunity to test SGX’s product resilience.
• A critical success factor the Group has built up is to support deep liquidity in its key product offerings. We believe that once a strong level of liquidity is created within a trading venue, it is harder for a rival to come in and take away market share – even if the pricing is competitive.

Deep product liquidity

• An example of its deep liquidity competency is the SGX Taiwan Index Futures Contract. SGX has been a primary trading venue for this contract. In 3Q20, the MSCI version of the contract migrated to HKEX, while SGX introduced the FTSE-Russell version. At the same time the MSCI Taiwan contract also continued to trade on SGX during the quarter.
• We observe that despite being introduced at the same time, the FTSE-Russell Taiwan Contract on SGX saw 10x higher volumes vs. the MSCI Taiwan Contract in HKEX. Also the volumes of the MSCI Taiwan Contract on SGX remained stable between 2Q20 and 3Q20 despite an identical product being offered in Hong Kong.
• We believe this is a key example of the strength of SGX as a trading venue and it is harder for competitive pressure to erode share simply by offering an identical product elsewhere without the visibility on liquidity.

Strong product market share

• SGX has also been able to create strong market share in key products. This in turn supports deeper liquidity. This provides a critical stickiness from competitive products from other trading venues – even if they are larger markets.
• Examples of this include SGX’s CNH USD FX Futures Contract as well as the USD INR FX Futures Contract. In both these cases, similar contracts are listed in larger trading venues such as HKEX and CME. Nevertheless, SGX has been able to preserve and grow its market share.
• Separately, the Group has built a strong domain in commodity derivatives including the steel supply chain and rubber. Structural growth in affluence in Asia, rising urbanisation together with Singapore’s commodity hub status, complements SGX’s product offering. We believe this provides a significant strategic advantage to SGX over other regional exchanges.
• According to management, SGX is deepening its product suite in derivative products to include more currencies, commodities and equities. An example of this is Single Stock Futures (SSFs). SGX offers a selection of SSF that cover Singapore and Indian stocks. In June 2020, it launched 10 SSF covering some of the larger market cap components of the MSCI Singapore Free Index. Off a low base, SSF volumes saw a 180% y-o-y increase in FY20 and we estimate continued strong growth in this segment as SGX introduces new SSFs as well as growing liquidity for its existing offerings.
• Overall, we estimate SGX’s existing derivative contracts to expand at 11% CAGR between FY20-23E. The introduction of new contracts - especially as SGX leverages its FTSE-Russell partnership - can drive growth to surprise on the upside, in our view.
• This should be a key driver in keeping overall liquidity for derivatives at healthy levels. Monthly derivative open interest to total contracts averaged 30% since December 2015.
• SGX’s deeper derivative liquidity offering becomes clearer when looking at monthly derivative open interest to total volumes by product type compared to HKEX – the primary competitor financial centre for Singapore.
• In both product groups, SGX has consistently displayed significantly higher liquidity, we observe.

Fixed Income Centre

• SGX has seen strong growth in volumes as a Fixed Income listing centre. Singapore is a wealth and fund management hub with total assets under management of S$4 trillion in 2019, according to the MAS. This has been increasing at a CAGR of 11% in the past 5 years.
• With a broad level of liquidity, we believe Singapore should continue to benefit as a bond listing destination. In year-to-date 2020, 90% of total bonds listed were from overseas origins. Additionally, as we discussed earlier, an accelerating shift to exchanges for bond trading and listing globally should further strengthen SGX’s advantages here, in our view.
• Separately, Singapore’s position as a Global FX centre, further strengthens its attractiveness as a bond listing destination. SGX’s wide FX futures and options product suite complements this offering investors hedging opportunities.

Cross Asset Margining enhances cost-saving appeal

• Cross Margining allows for the netting of margins across correlated derivative products. This allows for margining cost savings for market participants and also facilitates them to hold more exposure for a given quantum of margins.
• Many exchanges offer this facility. However, given SGX’s wide product suite, this allows for broader cross-margin applications to market participants. This should in turn support better liquidity across products, in our view.

Monetising data and connectivity

• Increasing use of technology in trading and rising share of high-frequency, algorithmic trading is driving client demand for better connectivity to SGX’s IT infrastructure. SGX monetises this by offering trading system connections, network linkages and data-centre co-locations for market participants. Increasing derivatives connectivity subscriptions should be a key driver for growth here going forward given more derivative product listings and rising liquidity in this segment.
• In the financial indices segment, the Group provides independent index calculation services as well as its own proprietary indices. These include the ‘iEdge’ branded indexes on segments such as S-REITS, Sustainability, APAC Dividend REITS etc. Additionally, the Group’s purchase of Scientific Beta in February 2020 should give it access to proprietary ‘smart-beta’ indexes. SB was established in 2012 by the EDHEC-Risk Institute Asia. From 2010-2019, its assets under replication has increased 10x.
• As we discuss earlier, ‘smart-beta’ products should see significant demand going forward and SGX’s positioning with Scientific Beta should allow it to be a credible player within this field.

Cash Equities: Slow growth, cash cow

• Over the past 10 years, SGX’s cash-equities revenues have contracted at a 1% CAGR. FY20 delivered the highest revenue since FY13, driven by a COVID-19 trading boost largely due to higher retail participation. This is likely the exception rather than the rule, we believe. Indeed, FY19 segment revenues were the lowest in our records since FY08.
• We expect segment contributions to continue to contract going forward. This could primarily be driven by limited hinterlands available to SGX to keep cash equity momentum supported, as well as limited sectors offering attractive listing valuations. Nevertheless, the cash-equities segment has strong operating leverage offering continued dividend visibility.
• Unlike some of SGX’s regional rivals such as Malaysia and Thailand – SGX has a very small domestic institutional or retail trading base. Also, it has no large liquid neighbourhood linkage - like HKEX’s bridge to Mainland China. Indeed, in Malaysia nearly half of trading volumes are driven by local institutions, while local retail investors account for nearly 40%. In Thailand, local institutional and retail investors account for nearly 50% of trading volumes.
• As a global financial centre, funds domiciled in Singapore invest globally. Therefore, SGX does not have much of a domestic support baseline. SGX does not publicly disclose equities trading volume by investor type, but we see that consumer lending for S$ share financing by the banking system has been losing steam. This implies that overall retail participation is structurally weakening in Singapore, in our view. As a result, we believe market velocity in Singapore has been capped compared to other regional markets – especially HKEX.

Limited niche sector valuations

• Historically, SGX has only a handful of unique sectors that offer materially better equity valuations and liquidity. Examples include S-REITS, Semiconductor Manufacturing, Healthcare and some Consumer names. Especially in the current environment, with the exception of S-REITs, we believe it is hard to argue that SGX has strong niche market dominance in any of the other sectors. This is different from its suite of derivative products where SGX has several key offerings with deep liquidity and market share.
• In the past, it has tried to introduce focused sectors – such as S-Chips, Offshore & Marine, and Palm Oil - but the track record has been mixed. Contrastingly, Hong Kong and China have successfully leveraged their deep domestic liquidity to offer clearer niche sectors than SGX, we believe. Similarly, many of the regional exchanges have also leveraged their core-domestic industry sectors – such as Palm Oil in Malaysia or Consumer in Thailand – to offer differentiation.
• As a result, over the long term, we believe SGX’s competitive advantages as a listings destination may erode viz-a-viz North Asia and specialised sectors in regional exchanges.
• Indeed, since FY12, de-listings have outpaced new listings by 40%. We believe this trend is unlikely to reverse going forward.

Range-bound average daily value traded (ADV)

• Given the limited headroom for listings, overall market velocity and value traded are likely to remain capped, in our view. Over the past 10 years, SGX’s average daily value traded (ADV) has averaged S$1.2b with a standard deviation to mean of around 12%.
• According to management, SGX’s retail contribution to ADV is typically 20%. Such a low proportion further dampens liquidity and by extension keeps overall ADV in a narrow range.

But a little can be a lot

• The structural disadvantages we discuss in earlier sections means that SGX’s cash equities business is ex-growth, in our view. However, when placed in the context of BCG’s Growth Share Matrix, we believe that this business segment displays the characteristics of a ‘Cash Cow’. It is low growth, but commands high market share – given it has a monopoly as the sole equities trading venue in Singapore.
• As one of the largest markets by capitalisation in ASEAN, the cash-equities segment enjoys scale as well. This positioning is unlikely to be challenged in the medium term, given limited policy discussions on liberalising and introducing new trading venues in Singapore.
• Within this backdrop, we believe the cash equities segment should benefit significantly from high operating leverage. SGX does not disclose direct operating costs by segment. We have derived this based on a set of assumptions detailed in Fig38 of PDF report attached below. From this we see that SGX requires an ADV of around S$580m to ensure direct opex is covered. All ADV above that flows directly to EBITDA. Over the past 5 years, SGX's ADV has averaged S$1.2b – 102% above this minimum.
• Over the next three forecasts years, we conservatively estimate SGX's ADVs to average S$1b annually – levels last seen in FY19 – with market velocity falling to 30% from the COVID-19 trading driven 37% in FY20. The risks here are on the upside, especially following the US presidential election victory by Democrat Joe Biden – which is strategically expected to favour Asian risk assets.
• As a result, we believe the cash equities segment should continue to benefit from strong operating leverage despite being in an ex-growth phase. This should provide significant support for SGX’s dividend visibility going forward.

Average daily value traded (ADV) does not drive share price

• Historically, there has been a tendency to link SGX's share price performance to ADV. The argument being that lower the ADV, lower the earnings and therefore, weaker the share price. Our analysis shows no significant correlation exits between SGX's share price performance and ADV across long or short timeframes.
• Given the narrowing contribution by cash-equities to overall earnings, we believe a correlation is unlikely to develop going forward either.
• Separately, given the low participation of retail, there is very little correlation between market volumes and interest rates. This is unlike North Asian markets such as China where retail participation accounts for 70% of volumes across national exchanges. According to SCMP, China added 6.4m new retail accounts in the first 5 months of 2020 – more than the population of Singapore. As a result, we believe despite the current low interest rate environment outlook, it is unlikely to translate in to ADV upside for SGX.
• Given the market is weighted more towards market makers (around 10% of ADV) and liquidity providers and institutional investors (more than 60% ADV), we believe clearing fees effectively will be tight going forward. Since FY12, fees have been coming off by around 1.1% annually. Conservatively, we assume clearing fees to continue to see downward pressure as the market mix continues to tilt towards market makers, liquidity providers and algo-trading.

Unchallenging valuations; Initiate coverage with BUY

• SGX's share price is trading at a 12-month forward PE of 21.7x. This is at its long-term average. While SGX has been listed since 2000, we define long-term from the period starting from 2012. This is to reflect the broader internationalisation of the Group and its diversification in to derivatives etc. ramping up and reaching a level of maturity. The decade prior to this, SGX’s primary strategic direction was as a cash-equities exchange. This measure also excludes the volatility during the GFC.
• We believe these valuations offer a decent entry point to the stock. See PDF report attached below for details on derivation of our SGX target price.
• Historically, SGX has been viewed as a dividend-yield play. Here the stock is offering a 3.5% FY21E dividend yield. Given its absolute dividend payment policy, SGX offers superior dividend visibility amongst yield stocks, we believe. SGX’s latest policy pays out a dividend of S$0.08 quarterly. As a result, we estimate a dividend of S$0.32 for FY21E. However, we believe the risks are on the upside.
• See SGX's dividend history. With the exception of FY20, SGX’s dividend payout ratio has consistently been above 85% in the past decade. In FY20, earnings grew 21% y-o-y – the highest in a decade. This was underpinned by a strong growth in cash-equity volumes (+26% y-o-y ADV y-o-y) driven by liquidity and QE measures. However, overall COVID-19 bearish macro concerns seem to have kept the dividend payout ratio at a conservative 69%. As a result, going in to FY21-23E, we have conservatively assumed only a 75% payout ratio.
• See SGX Share Price; SGX Target Price; SGX Analyst Reports; SGX Dividend History; SGX Announcements; SGX Latest News.
• Continue to read the 41-page PDF report attached below for complete analysis on Singapore Exchange Ltd (SGX:S68).

Thilan Wickramasinghe Maybank Kim Eng Research | https://www.maybank-ke.com.sg/ 2020-11-16

SGX Stock Analyst Report BUY INITIATE BUY 10.77 SAME 10.77