Investors can subscribe to the initial public offer of Multi Commodity Exchange of India (MCX), the largest commodity exchange in India. MCX had a 87 per cent share in total commodities trading turnover for nine months ended December 2011.

MCX is the dominant domestic exchange for trading in bullion, energy and base metals. Its drive to expand physical infrastructure and on-going product innovation — mini and micro contracts of gold and silver have helped it gain market share.

Among the commodity bourses in India, MCX also has lower regulatory risks. Bullion, metals and industrial commodities may be less susceptible to policy intervention than agricultural commodities.

At the upper-end of the price band (Rs 1032), the offer is being made at 18.4 times the company's estimated FY12 earnings. This is at slight premium to other global exchanges which trade at 17.5 times.

The valuation looks attractive, given the under-penetrated commodity markets in India. Improving margins due to operating leverage, on the back of expanding turnover, suggest strong earnings growth.

For the nine months ended December 2011, MCX received much of its revenues (82 per cent) from transaction fee. Membership fee and annual subscription fee accounted for 3 per cent of revenue, the rest made up by other income on the sizeable cash and investment holdings.

Strong business growth

The turnover on the exchange grew at 46 per cent compounded annually over the period 2007-08 and 2010-11. Transactions so far in this fiscal are 41 per cent higher than the whole of last year. Thanks to high rate of growth, MCX's market share in domestic commodity trading has improved from 45 per cent in FY06 to 87 per cent now.

The total income grew at 28.4 per cent annually, though transaction fee has been reduced over the years to drive volumes. Profits before tax grew at 66 per cent, excluding other income.

The core operating profit margins have improved from 27 per cent in FY-08 to 67 per cent for the nine months ended December 2011. Given the low incremental costs involved in the exchange business, high operating margins appear sustainable.

The bulk of MCX's transactions come from silver and gold (65 per cent of the total), followed by crude oil and copper. Transactions in silver and gold have been driven by rising investor interest in bullion on the back of their rising prices in recent years.

MCX's moves to reduce contract sizes in bullion by introducing 1kg ‘micro' silver contracts, 1 gram gold ‘petal' contracts, have helped broaden participation in these segments.

As the clearing of trades is also done by MCX's 100 per cent subsidiary, MCX Clearing Corporation, it is exposed to the risk of payment defaults by the parties. However, incidence of default has been low, given the margin requirements.

Business prospects

Despite being a nascent business, commodity futures trading has been attracting rising trading interest in India in recent years. Value of commodity derivative trades has grown at a 42 per cent compounded annual growth rate in during the period FY08 and FY11 compared to 30 per cent for equity derivatives (NSE).

One, higher volatility in global commodity markets and the outperformance of gold and silver in the commodity pack have contributed to trading and retail interest in commodity trading. Two, higher commodity price and rupee-related risks have prompted actual users, helped by easier regulations, to also hedge their exposures.

MCX has helped this process by expanding its reach by nearly a third in the past nine months. The total number of terminals have also increased by more than a lakh to 2,96,000 terminals in the same period.

Expansion into new geographies may drive turnover going forward. The retail participation continues to be significantly lower in commodity exchanges as compared to equity exchanges offering scope for expansion too.

Opportunities aplenty

Some of the key growth drivers for MCX could also lie in policy changes. One, enactment of Forward Contracts (Regulation) Amendment Bill 2010 (which is expected to be tabled in the budget session) may allow institutional investors to invest in commodities; this is not allowed now.

Institutional participation is said to account for 50 per cent globally. Rise in participation of banks and mutual funds can deepen the commodity derivative market.

Introduction of options in addition to futures will also be a possibility that can significantly expand volumes. Globally, option volumes account for 50.8 per cent of total transactions in derivative trades according to Futures Industry Association. Given that options dominate turnover in domestic equity derivatives with a 75 per cent share of trades, this could be a potential game-changer for MCX.

Much of these volumes are driven by index options. As MCX is already maintaining a commodity index, it can swiftly introduce index derivatives, which allow investors to bet on the entire industrial commodity pack, once allowed.

Risks to the business

Recent interest in commodities trading, particularly precious metals, is stoked by rising prices and high volatility, that allows scope for large trading gains. A range-bound market or even a bearish one may curb interest.

Though even a sharply falling market lends itself to short positions, actual users may reduce their hedging exposures.

According to the prospectus filed by MCX in 2008, there was high dependence on top ten members, which accounted for close to 40 per cent of turnover. Since then, members have grown manifold. But with no new disclosures on this score, we do not know whether concentration risk has declined since.

Competition in the exchange space is rising with new entrants attracted to this highly profitable business. This is leading to a global shrinkage in exchange and membership fees, and a consolidation of smaller bourses with larger ones. Such a development could hit long-term profitability of MCX's business.

Given that the business of running a stock exchange is in itself a sensitive one, regulatory intervention both at the business and product level is a live possibility. In the near term, introduction of commodity transaction tax could affect volumes.

Issue details

The issue is ‘offer for sale' and the issue size is Rs 663 crore at the upper end of the price band. The offer opens on February 22 and closes on February 24. The shares of MCX, post-issue, will be listed only on the Bombay Stock Exchange.

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