ASX: Competition cuts in - pt 1

I first purchased ASX at $30 in mid-2010. Apart from a brief flurry when Singapore Exchange (SGX) launched its bid later that year, it has pretty much stayed at that level. They say you should be careful what you wish for but ASX must be the most boring stock I’ve ever owned.

The simple explanation is that profits and dividends haven’t budged over the period. In fact, 2012 net profit was 5% below that of 2008. That’s unsurprising. The sharemarket, one of the company’s main revenue drivers, has barely budged since its initial recovery from the global financial crisis.

There is a more nuanced and accurate explanation, of course. Apart from the failed merger, Chi-X has opened up a competing exchange and LCH.Clearnet looks likely to win a licence to set up a clearing operation. What was once a clear monopoly future has become murky and overcast. Investors have parked the company on a generous yield, waiting for clarity.

Such antipathy towards a stock often foretells opportunity. But it’s only useful if we can reach a conclusion that the market is overstating the risks and that the price includes a broad margin of safety. That’s the aim of this three-part series.

First, we’ll look at ASX revenues from its traditional sharemarket businesses that contribute less than half its revenue. Then we’ll look at the other sources of revenue, such as derivatives, information and network services. Finally, in part three we’ll pull it all together to see if we’re getting that all-important margin of safety.

Listing and issuer services

Let’s start at the beginning. Listing on the ASX gives companies the opportunity to raise (cheaper) capital, offers shareholders liquidity and protects investors through higher levels of disclosure. Listing also raises a company’s profile.

In return, ASX charges issuers for listing new shares, plus an annual retainer and additional fees for further share issues (entitlement issues and the like, known as ‘secondary’ capital raisings). The fees are size-dependent but the average initial listing fee was $63,160 in the 2012 financial year and the average annual fee was $27,388. With 2,211 listed stocks at the end of 2012 and 99 floats, total revenues amounted to $133.4m.

This area of ASX’s business isn’t under direct competitive threat. Chi-X has not announced plans to offer listing services, although it’s a possibility. In the US, the NYSE and Nasdaq both list stocks, while the BATS exchanges already list exchange-traded funds and have plans to list equities.

Other exchanges will eventually list Australian stocks but, as has the NYSE, which retains 75% of the listings market, ASX should retain its market dominance in this area.

The listings business also offers expansionary opportunities. It could, for example, expand the range of listed products to include more exchange traded funds, overseas stocks and, starting next year, government bonds, which ASX hopes will aid the development of a bigger local corporate bond market. ASX is also aiming to make it easier for small and mid-cap companies to raise capital and is introducing its own bookbuilding service, ASX BookBuild.

The other main opportunity in this area is, quite simply, an increase in capital raising activity. This has been slow, especially with regard to floats, the number and dollar value of which have a disproportionate affect on revenue because of their higher fees.

Cash market trading

Cash market trading is the trading of shares on the market, with the ASX clipping the ticket. The amounts are so small that investors don’t notice (they get taken out of your broker commission), but in 2012 they added up to about 6% of ASX revenue.

New competitor Chi-X hung out its shingle on 31 October 2011 and has already snared about 7% of this market, a figure that will surely rise. A quick look at the US experience shows the likely effects. The formerly dominant NYSE captured only 27% of US equity trading last month, with the remainder going to a range of alternative exchange providers.

Australia is a smaller market, so you’d expect less fragmentation than in the US. Even so, the effects of competition are already evident. ASX has made pre-emptive price cuts ahead of Chi-X’s arrival, taking the average fee per dollar of value traded down from 1.23 basis points (hundredths of a percent) to 1.00 in 2011, before a slight recovery to 1.05 in 2012.

Volume is also leaking out to so-called ‘dark pools’. Here, large dealers match orders without sending them through an exchange, saving costs and avoiding showing their hand to other investors.

Even ASX chief Elmer Funke Kupper sees a role for dark pools, when, for example, very large parcels of shares are being traded. But if too much of the overall trade takes place off-exchange, it can harm transparency (and thereby confidence in the system) and price discovery. The more people that trade through a single exchange, the better the fix on what a share is worth.

At some point, regulators will need to limit off-exchange trading – we'd suggest before it reaches half of all trading. ASX estimates that in the first six months of 2012, dark pools attracted 25% of all trading, peaking as high as 43%. Action may not be far away.

Whilst ASX isn’t removed from competitive threats, it should be able to control market share losses by further reducing prices. As it only accounts for 6% of revenues, there’s some flexibility to do this. Either way, though, it means less revenue. We expect ASX’s cash market trading revenue to continue to fall, although this might be ameliorated somewhat by a pick-up in trading volumes, which are still well below their 2008 peak (see Chart 3).

Cash market clearing and settlement

After a trade a ‘clearer’ steps in—for a fee—to guarantee the fulfilment of each side of that trade. This is followed three days later by ‘settlement’, when money changes hands and the shares are registered in their new name.

Currently, ASX undertakes all the clearing and settlement for trades on ASX (and Chi-X)—via ASX Clear and the CHESS settlement system. Last year, each function contributed about 7% of revenues.

Dark pools are again a concern because if the trades don’t take place on an exchange then they won’t clear and settle through the ASX, either. A more direct threat is posed by LCH.Clearnet, a major international clearer, which has made an application for an Australian clearing licence.

Keeping clearing and settlement onshore was a major reason given by Wayne Swan for blocking the proposed merger between SGX and ASX. It would be an about-face if the government allowed it a licence. Rumours currently suggest Swan will do just that, with conditions that save face.

It seems likely that ASX will face the same problems in clearing as in trading: a Hobson’s choice between reduced margins and falling market share and, most likely, quite a bit of both.

As with trading, though, the context is important. Cash market clearing only accounts for 7% of revenues (settlement shouldn’t be affected). Again, a pick-up in sharemarket activity would provide a boost.

So ASX’s sharemarket business is undeniably under threat but the trading, clearing and settlement revenues account for only about a fifth of group revenues, while listing, which contributes the same again, has plenty of growth opportunities.

In Part 2 we’ll look at derivatives and information and network services, which also offer elbow room for optimism. That’s why we’re revealing our hand now. With the stock price down 7% since ASX: Result 2012 from 16 Aug 12 (Long Term Buy – $31.30), ASX remains a LONG TERM BUY. In the following two parts we’ll flesh out the argument as to why.

Note: The model Income portfolio owns shares in ASX.