Friday, September 15, 2023


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Exchanges are the core hubs of financial activity when it comes to stocks, shares, some traded bonds and in today’s context, ETFs, derivatives and a suite of financial instruments As such, today’s idea is another Singapore company that has built its business as the electronic trading marketplace for stocks, bonds, derivatives and other financial instruments. 

The Singapore Stock Exchange or SGX is Asia’s most international multi-asset exchange and is one of the most profitable companies in the Straits Times Index with operating margins at c.50% and ROE at c.30%. It has been a phenomenal compounder since IPO. It started trading at 30c back in 2001 and the share price today is $9 and its market cap is slightly shy of SGD10bn while its revenue topped SGD1bn for the first time in 2021.

1. Fundamentals

SGX, like many other global exchanges which are highly profitable, trades like a start up with its market cap at c.10x of its revenue (i.e. c.10x Price-to-Sales) but it is justifiable because profits are ridiculously high. The key difference: startups at 10x Price-to-Sales are usually still in red. They are selling a concept, a dream. Exchanges have made those dreams reality, churning out crazy profits. Importantly, valuations based on earnings, as we shall see later, make sense. We will also compare across different exchanges, they are all drowning in profits. 

Why are exchanges so profitable? 

First, the business has no cost of goods sold. The platform provides the venue for buyers and sellers to transact. There is some cost but it is negligible compared to a manufacturer requiring raw materials or airlines requiring heavy investments to buy airplanes. Furthermore, when the platform establishes itself as the venue of choice, naturally it attracts more buyers and sellers. Like grocery stores and marketplaces, exchanges are about connectedness. The more you connect market participants, the more others will want to join. In financial markets, this translates to liquidity, the ease to buy and sell shares, bonds and other financial instruments. If you wanted to buy shares of Singapore Airlines, well, the Singapore Stock Exchange is most liquid exchange to buy from and for some retail investors, it is also the only place to get those shares because they do not have global brokerage accounts or are simply not comfortable to buy the depository shares or receipts on other exchanges. 

This brings us to the second point. Exchanges are also monopolies. At the height of the FAANG boom, if you wanted to trade the FAANG* stocks, the natural venue is NASDAQ. Before that, if you wanted to trade the cool China internet names or industrial names during China’s boom in 2003-07, you got to go to the Hong Kong Stock Exchange and in the 1980s, if you wanted Japan exposure, there is only the Tokyo Stock Exchange. Singapore stocks do not have the same drawing power but the SGX team has more made up for this shortcoming by targeting very niche instruments and becoming the marketplace for trading such instruments. 

To list a few examples, SGX today has positioned itself to be the exchange for commodities like iron ore, rubber, some petrochemicals and certain types of forex and futures derivatives. In the past, SGX was also a pioneer in launching REITs and ETF products in Asia and continues the lead today with a large number of listed REITs and it recently established itself as one of Asia’s largest international trading venue for Chinese fixed income ETFs.

Building on core bases such as fixed income and cash equity trading and clearing, securities settlement and depository management, SGX has also branched into the indices and connectivity (co-location) businesses, which provides market data and collects licensing and subscription fees, which forms the base of its recurring revenue. This helps to reduce the volatility of earnings as these businesses are less impacted by market volume. By my estimate, recurring earnings from such operations contributes c.25% of overall profits and will continue to grow (see segment information above). 

The crux of the exchange business is also its scalability on the same platform with very little additional overheads required when growing revenue. This can drive supernormal profits thanks to the proliferation of electronic trading. Trading systems are not as expensive as banking systems and capex intensity is very manageable at c.3-4% of revenue (c.SGD30-45m). Additional trades simply create revenue that drops straight to profits. For banks, their systems need to handle ATM withdrawals, cross-border money transfer, fraud detection which incurs a lot more costs.

Besides systems, SGX has labor cost as the other big cost component, as with most other exchanges. It employs c.1,200 people and pays out c.SGD240m in salaries. There is also processing costs and royalties but those are smaller compared to IT systems and salaries. The end result is this high margin (OPM at c.50%) cash generating machine churning out almost half a billion in net profits which is almost fully paid out as dividends annually.

This story is the same as we look across global exchanges:

SGX is also highly free cashflow (FCF) generative. It only had a single year of negative FCF in 2001 when the dotcom bubble burst. Since then, the company made c.SGD300-600m of FCF annually over the last 10 years which it is mostly paid out as dividends to shareholders. The largest beneficiary of which is Temasek, which owns 23% of SGX and therefore receives SGD60-120m annually which has more than covered the original investment cost after collecting this amount for the last many donkey years and yet the stake is still worth c.SGD2.3bn today. 

*FAANG was the acronym for the hottest internet stocks from 2015-2022: Facebook, Apple, Amazon, Netflix and Google, before Facebook and Google changed their corporate names to Meta and Alphabet respectively.


Is it too good to be too profitable? The affirmative answer to this question is one of the key risk for SGX. When the company has money coming out from its ears, management simply cannot resist the urge to spend. Over the last few years, SGX spent more than half a billion dollars buying companies and goodwill on its balance sheet is now SGD708m which is c.45% of its equity. If this is impaired, the share price would collapse. 

The second risk is competition and how can SGX stay relevant. As alluded above, Singapore is not Hong Kong or NASDAQ and we do not have sexy stocks or sectors that can drive investors to come to trade. The SGX model is built diligently on niche markets which could simply migrate elsewhere tomorrow. SGX’s management knew this and desperately wanted to create stronger business moats. In 2011, SGX tried to make a joint bid for the London Metal Exchange (LME) after failing to acquire ASX, the Australian Exchange. LME was ultimately sold to SGX’s arch rival HKSE for c.USD2.2bn.

It is difficult to say if SGX have strong moats around its niche instruments. The mitigating factor is that SGX has managed to grow its revenue steadily from c.SGD200m in 2013 to more than SGD1bn today. In some ways, the SGX growth story draws parallel with Singapore’s own story. We have nothing yet we built a modern city state that thrives on efficiency and effectiveness. Things just work and foreigners loved it! Now Singapore is well-known as a global financial hub and that has contributed to SGX’s moat directly.

2. Technicals

Despite the strong business model, SGX’s share price has gone through a roller coaster ride during the pandemic. It rode to a $11 high and then dropped almost 1/3 to $8 and is now closer to $9 today. The main reason could be the dividend, which wasn’t increased when everyone expected them to do so for FY ending Jun 2023. The other could the risk that we discussed above, the company is squandering away the money into bad M&As. 

For the above reasons, share price is not too far from the pandemic low of $8. Recall that this is a level at the height of global pandemonium during covid and market participants capitulated. The most bearish sellers sold out and the stage is cleared with all selling pressure abated. As such, prices then (around Mar 2020) marked a strong support level and we are at a mere 10% above that. This makes things interesting.
$8 has been a very strong support for the stock over the last 5 years and if we go further back in time it was hovering at $6 for a long long time. But it is very hard to imagine SGX would trade to that level because that would mean that dividend can be c.6% and PER is at 13-14x which would make it the cheapest exchange (based on the peer list above) by 7-8 turns and provide us the opportunity to buy a high 15-20% sustainable ROIC at c.8% FCF yield. 

So I would draw the downside at $8 and not $6. Conversely, the upside is dictated by the recent $11 but also the valuations of its peers which can be as high as 30x PER, 19x EV/EBITDA and as low as 3% FCF yield. Assuming SGX can generate 50c in EPS in the near future and applying 25x to that, we are talking about the stock going to $12.5. This does not account for the net cash it has on its balance sheet. 

So in terms of risk reward, we have the risk of falling to $8, which is 20% downside from here, but the upside could be $11-12 which is 15-25% upside. Even if we assume the stock falls to $6 which is a scary 47% downside, we have strong compounding as the tailwind which means the stock should double over next 6-7 years. The strategy would be to buy on dips if the stock for some reason collapses to $6, then we will buy more and enjoy much more compounding in the years ahead.

3. Valuations

As with the previous ideas, let’s use the usual three valuation methodologies (FCF, EV and PE) to triangulate to a more concrete intrinsic value. On FCF, we have it at c.SGD500m and using the same 3.5% FCF yield that we used for Vicom given its strong fundamentals, we get to SGD14.3bn and adding back its SGD200m cash, we get to SGD14.5bn of market cap. 

With Enterprise Value or EV, SGX will likely achieve an EBITDA of c.SGD700m in Jun 24. Using 15x which is near the industry average, we get to EV of SGD10.5bn and again adding back cash of SGD200m, we get to market cap of SGD10.7bn. 

Lastly, using Price Earnings Ratio or PER, SGX should be able to achieve Net Income of SGD500m in Jun 24 and using PER 23x which is again the industry average we get to SGD11.5bn and adding back its SGD200m cash, we get to market cap of SGD11.7bn. 

Intrinsic Value 

Taking the average of the three market caps, we arrive at SGD12.3bn and translating this into share price, we get to c.$11.5 in terms of intrinsic value per share (c.20% upside). Co-incidentally, this is very close to the all time high reached during the height of the pandemic in mid 2021. Meanwhile we also get to collect c.3.6% dividends annually. 

To sum up, SGX is an interesting bet on the highly profitable stock exchange business model and the continual success of Singapore to be a bigger financial hub and SGX grows it business moats in the various niche it has created in REITs, commodities, futures and derivatives. This is a good Singapore compounder to own and to keep buying on dips as long as management does not squander away the money. 

Huat Ah! 

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This post does not constitute investment advice and should not be deemed to be an offer to buy or sell or a solicitation of an offer to buy or sell any securities or other financial instruments.

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