Statutory Warning: This report may cause a reaction, and acting on it can be injurious to your wealth.
Note: This StockTalk analysis has been written by Sunny Gupta.
Most tribesmen reading this would know about the business moat (read how a business moat looks like) and its importance, and how identifying businesses with strong and durable economic moat is key to investment success (when properly combined with other important ingredients like margin of safety).
It is also evident that businesses that possess strong and durable economic moat tend to have little competition, high margins (or return on invested capital, ROIC), low working capital needs and low to zero debt.
One such company in the Indian context is Multi-Commodity Exchange of India Ltd. (MCXIL), the only listed “financial security exchange” stock.
Let’s see if this good looking business is indeed beautiful, and if it can also be a good investment opportunity.
Before we start the analysis, I want to introduce the readers to an interesting concept used in engineering projects is “Risk Log” or a Risk Register.
A Risk Log helps us collate various risks associated with a project and list their probability of occurrence and impact. This is a good thing for investing too, since, as Charlie Munger said, “Don’t go where you may die”, the objective of business analysis should be to identify the risks associated with the investment, and then weigh them all to take an informed investment decision.
On this thought, I’d keep collecting potential risks as we identify them during the course of analysis in our Investment Risk Log (see below).
Let us start looking into the business of MCXIL.
MCXIL is India’s largest commodity derivative trading exchange, and also the world’s third largest. Further, it boasts of the largest trading of silver and gold futures (after all, we Indians love these precious metals so much!).
While commodity derivatives trading maybe a complicated, stressful and dangerous profession as a trader, it is simple to understand the business of a commodity derivatives trading exchange. The exchange provides a platform for traders to exchange cash and securities, with well-defined rules and framework. One trader sells a security while other buys and the exchange (like MCXIL) only services them “exchange”, and receives a transaction fee in return of this service.
In order to serve these transactions, MCXIL needs to spend money on the following key heads:
- Employee compensation
- Software charges, for the intricate software system and its maintenance which is needed to ensure trading is accurate and timely, with nearly zero failures.
- Other SG&A expenses (sales, general, and administrative)
The major cost items for the company are its software support charges (30%), and employee expenses (20%, where total strength of employees was 266 as on 31st March 2012).
However, an inference from the cost model for MCXIL is that their costs are relatively fixed, as they’ve build infrastructure to support 10 million daily trades, while the current daily volume is only around 1.5 million trades. This means that their cost of operations will remain relatively constant for a long time (they can become 6 times bigger without having to spend on capex), and as volumes increase, their operating margins will improve.
This is also evident from the fact that MCXIL’s operating margins have increased from a low of 20% to a healthy 60% in FY2011-12. Hence, looking at the business as a “cash generating system”, we can picture MCXIL using the following diagram…
How have revenues grown in the past?
We note that (see chart taken from FY11-12 annual report below) MCXIL has been able to maintain and grow its market share in the past five years. There have been many attempts by other players, especially financial institutions like banks and brokerage firms, but we still see that MCXIL has been able to maintain its dominant market position by holding more than 80% of the total market in India.
If this can continue going forward, MCXIL can grow at the same pace as Indian commodity futures market. However, we’ll need to watch out for reasons which can bring tough competition going forward, and MCXIL may not be able to maintain its market share to such a high value of 80%+ levels.
What kinds of transactions take place on MCX?
A study of its annual reports tells us that the contracts volume is focused in precious metals, which is as high as 60% of total transactions. This indicates risk of concentration in a specific segment. We’ll analyse this further in next section.
In fact, large part of the phenomenal growth in MCXIL’s revenues in the past is attributed to growth in precious metals segment, and this means that we should be conservative of the future growth of the company. We’ll take this up in the valuations section.
Next thing to study about a security transaction exchange is robustness of its services. Any technical issues arising in the services of MCXIL can lead to dis-satisfaction within traders, who may incur large notional or real financial losses. And if such events occur (forget about them occurring frequently, they’re killers for financial service providers like banks, brokers and exchanges), they’ll lead to loss of revenues as people will switch to more robust exchanges.
Towards this end, MCXIL implements the following features, which makes its services robust (this is evident from the fact that it has grown its contracts volumes ever since it started operations in 2003, and also the fact that a Google search on history of “technical errors on MCX servers’ did not return any meaningful results, indicating near flawless operation since they commenced operations. Indeed, if someone remembers a technical glitch that occurred in the past, please share details of the same in Comments section):
- Fault Tolerant FTIL (Financial Technologies India Ltd.) server with 99.999% availability.
- Multiple mediums of connectivity like VSAT, VPN, leased lines etc.
- Strategic tie-ups with other major exchanges, financial institutions etc. This helps reduce risk and hedge positions.
While the above points do not guarantee that technical failures would not happen, it is evident that the company is cognizant of the importance of providing a robust trading platform, and this gives confidence to its clients, which may have been one of the loyalty factors leading to growth of the company in the past.
In order to study the economic moat and its durability, one should consider few key points, which we do here for MCXIL:
- Bargaining power of customers of MCXIL is not high, since they can’t command or negotiate for the transaction charges with the exchange. This is good for MCXIL since this allows them to pass on the costs and even increase their margins occasionally. This fact is evident from the fact that MCX has had a very good revenue growth while also increasing its operating profit margins.
- Bargaining power of suppliers of MCXIL is tricky to estimate. The only major cost for MCXIL is that of software charges, which it pays to Financial Technologies (FTIL), who is also the promoter of MCXIL, and holds a 26% (controlling) stake in the company. This relationship means that FTIL would not charge irrational amount in software services to MCXIL, and hence we can assume that bargaining power of suppliers is not too high or too low, and it has a neutral effect on the moat for MCXIL.
- Risk of new entrant for MCXIL is quite high, since the business is an asset-light, high margin business (low barrier to entry), which will attract a lot of competition. However, it is also important to mention that technical know-how and expertise are needed in setting up such a business, and continuous innovation in products and offering is key to sustain this high margin business. We’ll address this in detail later.
- Risk of substitute for MCXIL business is moderate. If a financial security provides traders to earn high returns with lower risks, MCXIL may leave commodity trading and deal with this new financial security.
- Existing competition for MCXIL has not proven to be a big threat, as is evident from the 80%+ market share of the company, and the fact that many attempts to setup commodities exchanges have failed.
Overall, based on the points mentioned above, we can say that MCXIL has a moderate economic moat, which is reasonably durable. Further, since it has demonstrated this growth for over 9 years now, and when many commodities exchanges came and went by, it is not by sheer luck that MCXIL has proven to possess this economic moat.
Indeed, we need to find what MCXIL is doing to withstand competition that’ll come its way in future.
Let us now study the financial health of MCXIL. We gather the following points after studying numbers in last 5 years’ financial statements…
- Improved operating profit margins as volumes of transactions have increased
- Zero debt throughout the 5 year period
- All capital expenditure needs funded from operating profits. MCXIL spent Rs 1.6 billion as capex in last 5 years, and it earned over Rs 6.8 billion as operating profit, indicating very good incremental return on capex.
- A significant non-operational revenue stream from interest and dividend income, and sales proceed of investments. In fact, we see that a major part of net-worth of the business is invested into current and non-current investments, which generate about 20% of annual revenues. Hence, if we take whole of equity as base, we get a near constant ROE of 28% for last 5 years. On the other hand, if MCXIL were to hypothetically liquidate all of its investments and give away a major part of it back to shareholders as dividends, the equity base will reduce to 1/3rd of what it is today, but operating profits would only come down by 25%, resulting in a true ROIC of over 50%.
- Cash flow from operations is also decent. In the last 5 years, only once has the CFO been negative on accounts of trade receivables. MCXIL generates CFO greater than PAT most of the times.
- As we’ve seen earlier, MCXIL can grow its contracts volumes by 6 times from where it is now, without any major increase needed in capex or working capital, and hence it’s in an excellent position to “grow for free”, and generate increasingly better returns for the shareholders.
After having a look at the business of MCXIL, we find the following characteristics…
- Consistent earning power which is growing as volumes increase
- High return on invested capital
- Near recession proof business, as human tendency to speculate doesn’t go away during recessionary times
- A business which needs to keep up with technology and keep innovating (susceptible to rapid change). However, presence of FTIL as the promoter helps MCXIL obtain the latest financial technologies in time.
- We didn’t talk a lot about it, but dividend payout ratio is healthy, at 15% of PAT on average in last 5 years, but it is not growing.
- Good cash flow situation, and very low working capital needs
Before we go and study what’s good about the business, let us find out the concerns for its future, since this will avoid us getting biased to the good, attractive things.
What Can Go Wrong?
In this section, we study internal and external factors to the business that can go wrong. Let’s start with things that are in control of the business.
Costs: Here’re few things on cost front that might go wrong, let’s see how probable they’re and add them to risk log accordingly.
- Write off costs due to defaulters: It is possible that a trader makes huge losses in commodity trading due to the leveraged nature of the trade, and he’s then unable to pay the exchange for the losses. MCXIL has adequate measures in place (like minimum networth, margin and MTM loss monitoring systems, along with limited insurance of members) to minimize any major risks of write off costs due to defaulters.
- Further increase in management compensation: Total cost in employee compensation was 10% of PAT for FY11-12, out of which, the CEO’s fixed compensation apart from ESOPs was Rs 1.7 crores, about 1% of PAT. We’re not sure if these numbers are high in relative sense. It is understandable that businesses like MCXIL will need professional management and considering the complexity of business, I personally think that CEO compensation is not too high, and employee compensation, like many other knowledge industries (consider a bank, or an IT company), employee compensation is a major cost for these businesses.
- Software charges: This is the biggest single cost head for MCXIL, and as we discussed earlier in “bargaining power of suppliers”, it is not a high risk that this cost will increase to exorbitant levels.
Overall, on cost front, risks of things going wrong for MCXIL are not so high, except that we need to keep a watch on top management compensation.
Innovation: While I’d not want to go into details here, the annual report and MD&A indicate various innovative offerings the company has come up with from time to time. The management has focused on quality and technology standards.
I believe that the management and promoter group are conscious about the fact that they operate in a very dynamic industry where innovation and timely delivery of new products which market needs is extremely important and rule for survival.
However, if the management doesn’t continue to innovate and keep pace with rapidly changing environment, it can be a big negative to the prospects of MCXIL business.
Management: Let’s now come to a very important factor in business analysis – the management. I strongly believe that while a good management may not be able to revive an ailing business, a bad management can easily cripple even an excellent business. So, let us put MCXIL management to test using the following checkpoints:
- MCXIL management has succeeded in maintaining healthy returns and performed good capital allocation, which is evident from the financial numbers we saw above.
- The management compensation is high, even if justified for the “knowledge industries”.
- The promoter (Financial Technologies), despite selling their stake in IPO, retains 26% controlling stake in MCXIL, which boosts the confidence that the parent technology leader believes in the future prospects of the business.
- It is unfortunate that top management has sold shares after CTT imposition.
- Nothing doubtful evident from related party transactions, which have majorly been with FTIL for software charges and asset purchase, and MCX ESOP Trust.
- Director’s report and MD&A doesn’t look over-optimistic and promotional. On the contrary, MD&A looks very reasonable where every statement is supported by data, and the analysis is balanced, listing both opportunities and threats equally.
- MCXIL’s board and top management is composed of right people from related sectors like FMC, banks, exchanges, academia, and other financial backgrounds, including financial technology.
- I performed some searches on ‘corporate governance issues” with MCX and FTIL, and found the following links (here and here). They do show some concerns about lack of transparency on part of FTIL management, especially in launching MCX-Stock exchange.
However, searching independent senior management names for any problems related to governance did not show up anything. But this doesn’t mean a green flag – rather, we’ll need to rely on scuttlebutt and people who know of any issues are requested to post in comments section.
Let’s now see what can go wrong on the external front.
Competition: Even though MCXIL has been able to maintain its market share to 80%+ levels in the past, rising competition can hamper this, leading to reduction in revenue growth for MCXIL, and as we saw above, the key for MCXIL to maintain and increase operating revenues is to increase volumes.
Government Control & Regulations: Government regulations and policy paralysis can impact MCXIL business in the following ways…
- MCXIL has a concentrated revenue stream from precious metal commodity futures transactions. As it happened recently, the government has increased the commodity transaction tax (CTT) on non-agri products, which will impact the volumes of MCXIL contracts. While management estimates that introduction of CTT on non-agri commodities will impact up to 20% of volumes for MCXIL, it has also taken steps recently to get aggressive on growing the agricultural commodities segments, and hence offset for the losses.
- Management relies on liberalization in commodities trading in India, which will be the next big source of growth and expansion for MCXIL and the industry. However, government may not do so for a long time, even though they’ve recently given autonomy to Forwards Market Commission (FMC), the regulatory body for commodities in India.
Threat of substitutes: As we studied in economic moat above, this is a moderate risk to MCXIL business.
Having studied what can go wrong, it’s time to look at the positive aspects of the business and its prospects in future.
What’s Good about the Business and its Prospects?
As we’ve studied above, here’s a list of what’s good about MCXIL’s business…
- Increasing operating margins as volumes increase, which means that MCXIL can become more profitable and gets full advantage of economies of scale.
- Healthy financial situation, zero debt, and a market leader position.
- As mentioned in MD&A, liberalization in Indian commodities trading regulations, which can open up this segment to large financial institutions like banks, mutual funds etc., and further, introduction of commodity options will bring in more revenues as then businesses can use more efficient financial instruments to hedge their raw material costs. Further, if FMC decides to remove CTT (as many experts believe that CTT is a killer for India’s commodity market which is still young and growing). Hence, introduction of commodities options, opening the market to financial institutions, and abolishment of CTT can turn out to be positive black swan events / positive catalysts to MCXIL business prospects.
- Large equivalent cash position which can help MCX make thoughtful acquisitions to grow. For instance, if MCX is allowed to acquire some agri-focussed commodities exchanges, it’ll help offset for the revenue losses due to CTT quite rapidly, as opposed to organically growing their agri segment.
The Investment Risk Log
Here’s a list of risks to our investment in MCXIL…
- Risk of new entrants with innovative products and offering that can greatly hamper the market share of MCXIL.
- Government regulations like retaining imposed CTT and not allowing commodities options or financial institutions to trade in commodities can become big negative catalysts to MCXIL business prospects.
- Increase in management compensation can impact profitability.
- Unknown problems with management and corporate governance can pose a risk to the investment.
As Vishal mentioned in his analysis of Amara Raja Batteries, this is the haziest part of the business analysis, and there’re strong chances that our valuation turns out to be wrong. Hence, we’ll try to find if we have sufficient margin of safety in our valuation estimate.
Let us first discount what we know – assuming that CTT will impact revenues for next year by 25%, and using past 2 years average (as the company has grown pretty fast in last few years, and taking longer averages will be quite inaccurate), we get the following:
- Average of last 2 years operating revenue, and reducing 25% thereof gives us an estimated operating revenue of Rs 3.4 billion for FY12 (with CTT in effect), and it gives Rs 1.9 billion as operating profit. Adding Rs 0.9 billion of average non-operating revenue (at 100% gross margin since this is interest and dividend income on investments), we get an estimated profit before tax (PBT) of Rs 2.8 billion. Using the trend for the business that “Free Cash Flow” is nearly same as PBT, we get a base FCF of Rs 2.78 billion.
- However, the business is still growing pretty fast, so let’s assume a 20% growth for next 5 years, 15% growth for next 7 years, and 2% thereafter. I chose 3-stage DCF since commodities industry in India is still in a nascent stage, and a lot of “reforms” are possible going forward. The growth rates chosen are definitely less than what the business has clocked in the past. Using this 3-stage DCF, 12% discount rate and the base FCF calculated in step 1, it gives us “Intrinsic Value of DCF per share” of Rs 1650.
On the average P/E front, we lack a lot of data – MCX stock has traded for less than 3 years, and leaving aside the last 6 months, it has traded at a P/E ratio of 20 or above. Assuming a more reasonable P/E ratio of 17, and the current EPS (based on reduced revenues due to CTT) of about Rs 50, we get a P/E based fair value based on historical P/E of Rs 850 a share.
Further, as we believe that the business can still grow at a good pace, if big negatives don’t happen, at the current growth rate of over 40%, a P/E of 20 (resulting in PEG ratio of 0.5 being an undervalued stock) is justified for MCXIL stock (for the period where it can still clock over 40% growth), and that gives a fair value based on PEG ratio less than 0.5 of Rs 1000 for the stock.
Using these three numbers, we get the range of fair value as Rs 1,165 to Rs 990. Taking the upper limit and different margins of safety, we arrive at the following table…
As I said, valuation can be quite incorrect, but I also believe somewhat in market dynamics, and I see that after CTT news, MCX stock price has taken good support at Rs 820 several times, and taking this “supporting evidence”, I’d consider buying MCX stock around Rs 820-840 levels which gives a decent margin of safety, provided all other “more important” considerations support a buying decision, and not just because I’m now anchored to this price level.
Well, after this analysis of MCXIL business, I can say that the business has got a decent economic moat, and while competition and regulations can pose a risk to revenue growth and its sustenance, ability and experience of management in adapting to the changing environment and innovating in bringing new values to the customers should remain key to future growth of MCX business.
If the business can manage to grow revenues like the way it has done in the past, while fully recognizing that law of diminishing returns always plays a role in slowing down growth rates, there’s a large potential for MCX to deliver very good value to shareholders, who are prudent in buying the stock at the right price, and doing a staggered buying while being cognizant of fast changing dynamics related to CTT and related regulations.
What do you think about this business and the investment? As an analyst, one can only study what “he can see”, but he must thereafter rely on critical reviews and the scuttlebutt others can bring in to the analysis, i.e., finding “disconfirming evidences” to make the analysis more rational and remove biases.
Hence, my mirror test begins, and I’ll sleep over this analysis, and try my best to avoid the bias of “I’ve done a great analysis, so let me buy the stock which is presently available around the safe purchase price Rs 825.”
Happy and safe investing 🙂
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