MCX: Positive exchanges

MCX is well-placed to capitalise on the expected growth in commodity derivatives

Investors can retain their holdings in the shares of MCX, the commodity exchange. Given that the market regulator SEBI’s move to open up the commodity markets is yet to play out, it is worth waiting to see how the dynamics of an open market unfolds for MCX.

Several negatives have weighed on the stock over the last couple of months, pulling it down to ₹750 from ₹1,000 levels in November. It started with SEBI’s nod to create universal exchanges in December — a move that allowed the NSE and the BSE to launch the commodity platforms.

The markets considered this step as a death knell for MCX, as the other two exchanges have a wider reach and financial muscle. However, the markets may have over-reacted as MCX can still be expected to soak up most of the volumes in the commodity markets. Even now, a broker who has integrated his commodity and equity operations can offer both these assets on the same platform to clients (SEBI amended the Securities Contract Regulation act in September 2017 allowing a stock broker carrying on the activity of buying/selling in securities other than in commodity derivatives to undertake buying/selling in commodity derivatives, and vice-versa).

MCX may still have to offer discounts when new players come in, but it does not see volumes on its floor drying up, given its long history in commodity market and its connect with the physical market participants.

In the December quarter, the company’s profit plunged by 47.5 per cent y-o-y, which caught the market off guard. But what was ignored was that the operating income (made from transaction charges) was down just 11 per cent; it was actually the lower other income following the drop in the value of treasury investments that pulled profits down. MCX has a large investment in debt mutual funds, and increase in bond yields caused prices to decline, resulting in mark-to-market losses.

There are several positive developments that are waiting to unfold for players in the commodity derivatives space, and MCX is well-positioned to capitalise on them.

The introduction of options, the go-head for alternative investment funds and bank subsidiaries to participate in commodity derivatives, and the possibility of opening the floor to MFs and PMS should all help the commodity derivatives pie itself grow in the next five years.

Risk-averse investors may, however, be better off waiting for 12-18 months before taking fresh exposures.

At the current market price of ₹750, the stock trades at a valuation of 23 times its likely one-year forward earnings. CME trades at similar valuations, but Intercontinental Exchange trades at about 18 times. MCX, however, is likely to have better earnings growth and, thus, commands a higher valuation relative to global exchanges.

 

 

Business drivers

MCX, like any other exchange, earns its revenues from transaction charges, and is exposed to risk from fluctuating market volatility. In the last one year, the volatility in gold has been very low, impacting volume. Demonetisation too had hit the physical gold market traders.

In 2017-18, the total average daily turnover (ADT) at the exchange was ₹21,192 crore compared with ₹22,560 crore the previous year, down 6 per cent. But there has been an improvement in the last two quarters — ₹23,825 crore in the March quarter compared with ₹20,228 crore in the December quarter, helped by robust participation across segments.

Volumes in commodity derivatives may move up over the next few years as they have been opened to institutional players. Improving liquidity can draw corporates which are currently hedging outside India, to MCX. End-September, the regulator allowed subsidiaries of banks to become members of commodity exchanges. Axis Securities has already taken membership with MCX. As it signs up with the top five-six bank subsidiaries, volume contribution from these players will be significant. These players may come on board by the next one-two quarters, according to the exchange.

The gold options contract, launched recently, is significant. Given that options are a better hedging tool compared to futures, it may draw more participation. Generally, in mature markets, the options-to-futures ratio is 0.2:1. Launch of options on market index is expected further improve turnover in this segment. MCX expects options segment to contribute 15-20 per cent of revenue in the next three to five years. MCX recently launched a futures contract in brass and is considering launching contracts on diamond, coking coal, petrol and diesel.

Margin to be under pressure

The exchange reported an operating profit margin of 37.9 per cent in the December quarter compared with 49 per cent in the September quarter, due to higher sales expenses. The exchange has been spending significantly on establishing a stronger connect with physical market participants.

But for the software support charge and product licence fee, which depend on revenues, the other expenses are under control. Operating margins may continue to be under some pressure in the near future.

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