ASX’s Elevated Cost Growth Unlikely to Be Sustained

Business Strategy & Outlook

The ASX to deliver a low-single-digit EPS compound annual growth rate over the next decade, with the wide economic moat protecting strong margins and enabling returns on invested capital to exceed the weighted average cost of capital. The capital-light business model and a lack of desire to undertake acquisitions should enable strong cash conversion, a 90% dividend payout ratio, and a debt-free balance sheet. The yield nature of the stock means the share price to be largely driven by bond market movements and central bank interest rates. One cannot expect competition to materially undermine earnings, despite the evolving regulatory and competitive landscape. One can expect long-term growth in market value to underpin EPS growth. The relatively reliable nature of earnings influences the medium fair value uncertainty rating. The ASX has long been protected by two significant barriers to competition through regulation and network effects. The federal government and regulators have sought to increase competition for nearly a decade, but the process of regulatory reform is slow and still has many obstacles to overcome. In March 2016, the government reiterated its desire for competition in cash equities clearing, which constitutes just 7% of ASX group revenue, but not in cash equities settlements, which make up a further 6% of group revenue. However, a government report found that even if competition were allowed in cash equities clearing, competitors are unlikely to emerge, as the regulatory requirement to maintain operations and regulatory capital in Australia reduce potential synergies for overseas clearinghouses. There are currently no proposals to introduce competition in derivatives clearing, ASX’s largest business (comprising around a third of group revenue), with obstacles such as cross-margining acting as a barrier to competition.

Financial Strengths

ASX is in good financial health due to its dominant Australian securities exchange, high margins, and capital-light business model. The company is debt-free and has been for many years, a situation to continue for the foreseeable future. The wide economic moat has protected consistently strong and stable EBIT margins of around 70% over the past decade, and as per forecast an average EBIT margin of around 65% over the next five years. Although revenue is vulnerable to market declines to some degree, the large margins limit leverage at an EPS level. A lack of capital requirements enables a dividend payout ratio of 90%, which one can expect to continue for the foreseeable future. ASX lacks an appetite for acquisitions, which is not a bad thing in one opinion. The company seeks to drive growth organically through product innovation and cost efficiencies. One cannot expect this strategy to change. ASX has a simple, maintainable capital structure comprising solely ordinary equity. Shares on issue have been reasonably stable for the past decade, with capital expenditures funded from cash flow. ASX also records participant balances on its balance sheet, which represents cash deposits that clearing participants are required to make to satisfy margin requirements on outstanding positions. This cash is invested in cash, as well as various money market instruments.

Bulls Say

Long-term earnings growth is underpinned by growth in the value of the stock market and protected by a wide economic moat. However, in the short term, earnings can be affected by market weakness, although EPS fell just 7% during the global financial crisis.
ASX has a wide economic moat underpinned by network effects and regulation. This competitive advantage to protect EBIT margins of around 65% over the next decade and a low-single digit EPS CAGR.
ASX is financially robust with a good balance sheet, strong cash flow, and tight cost control.

Company Description

ASX is the largest securities exchange in Australia with an effective monopoly in listing, trading, clearing, and settlement of Australian cash equities, debt securities, investment funds, and derivatives. Other activities include the technology services, enforcing exchange rules, and exchange-related data. The ASX demutualized and listed on its own exchange in 1998 and subsequently acquired the Sydney Futures Exchange in 2006.

(Source: Morningstar)

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