Value for money?

The Right Moves

Mobis Philipose

Indian stock exchanges have embraced the consolidation process occurring among financial exchanges globally. The Bombay Stock Exchange (BSE) has roped in Deutsche Börse and Singapore Exchange as strategic partners, close on the heels of NSE’s decision to allow NYSE as an equity partner.

“This is a firm beginning towards bringing the global markets to India,” said BSE managing director and CEO Rajnikant Patel in Mumbai, just after the recent announcement. Since the process of cross-listing securities between the two exchanges depends on regulatory changes it may take a while to materialise. But analysts expect Indian exchanges to begin benefitting immediately from information sharing on product development and technology.

However, no dramatic changes are expected, says C.J. George, managing director, Geojit Financial Services, in Kochi. “For that to happen, strategic partners would have to be given a more significant stake and involvement in the management of the exchange,” he says. Sebi regulations currently restrict foreign investors to only a 5 per cent stake, which won’t even get the foreign exchanges a seat on the BSE board.




What still makes local exchanges, such as the BSE and NSE, attractive to global exchanges is that cross-border alliances enable them to create global trading networks. That’s why similar deals are happening across the world. The NYSE Group recently entered into an alliance with Tokyo Stock Exchange, and Deutsche Börse entered into an agreement with Korea Exchange. As Frankfurt -based Deutsche Börse’s CEO Reto Francioni said recently, “We see the exchange business becoming increasingly global.”

Given the spate of deals, stock exchanges are also being re-rated. Hong Kong Exchanges and Clearing has more than doubled in value in just the past year, while Singapore Exchange’s stock has risen by 76 per cent. London Stock Exchange and Deutsche Börse have each risen by about 50 per cent in value.

NYSE paid Rs 500 crore, or 36 times the NSE’s consolidated FY06 profit, for its 5 per cent stake in the exchange. Deutsche Börse and Singapore Exchange’s 5 per cent stake in BSE cost about Rs 200 crore, or 42 times the FY06 earnings of the latter.

Such high valuations may seem out of line with current financial fundamentals. But for global exchanges, the investment is small change compared to the benefit of having a presence in India. Even for financial investors, valuations would not be a large concern, given the scarcity of investment opportunities in this space. T.V. Raghunath, executive director (investment banking), Kotak Mahindra Capital in Mumbai, says, “It’s a one-time, lifetime opportunity,” referring to BSE’s plan to offer 41 per cent of its capital to institutional investors.

While the full strategic value of global alliances could take years to exploit, the NSE is already poised to give investors good returns in the short term. Its turnover is set to grow by 44 per cent this year. This could translate into high earnings growth given the high operating leverage the stock exchange business enjoys. In fact, another year of similar growth could end up making the NYSE’s acquisition cost look cheap.

However, the BSE’s turnover is set to grow by only 20 per cent this fiscal, primarily due to its near absence in the derivatives market. Also, a staggering 65 per cent of the exchange’s profit comes from non-operating investment income, compared to just 22 per cent for the NSE. So, the benefit of operating leverage would not be seen as much in the BSE’s overall profit growth.

But BSE supporters say the exchange can still boost returns by building revenue streams in areas such as data dissemination, which it has not fully tapped yet. Besides, the opportunity for growth is much larger for BSE, given that it has a mere 2 per cent share of the derivatives market. For now though, like investing in the plethora of BSE’s small-cap stocks, an investment in BSE could well be a high-risk, high-return strategy.

Capital IDEAS
Manas chakravarty

At a conference in Mumbai recently, Ratnesh Kumar, head of India Research and India strategist for Citigroup Investment Research, had an interesting point of view about the high valuations in the Indian market. He pointed to the host of new business opportunities being explored in India, which currently sit on corporate balance sheets but haven’t yet started to earn profits. Obvious examples would be the insurance businesses in the books of banks or the exploration business in Reliance’s books. In many balance sheets, the value of nascent forays into retailing or into real estate would also need to be taken into account. Kumar says these businesses have “embedded value” and estimates that this would account for 1700 points of the Sensex. Facile comparisons of the Indian market vis-à-vis others need to factor this in. Kumar forecasts a fair value of 13,300 for the Sensex by December this year. Add to that a 10-20 per cent premium, and Citigroup’s year-end target for the Sensex is between 14,700 and 16,000.

The premium is added because of several factors, says Kumar. One of them is that Indian companies not only have strong earnings growth but also strong return on equity. This high capital efficiency deserves a premium. Also, there could be upgrades in profit estimates going forward, as happened last year. There is also the strength of the long-term India story. And finally, there is global risk appetite, which was in India’s favour a few weeks ago, but has since reversed direction.




The big question is whether there is a slowdown looming ahead. Sanjay Nayar, Citigroup India CEO, says his bank is seeing a slowdown in retail credit and mortgage growth, a point being repeatedly made these days by ICICI Bank’s CEO and managing director K.V. Kamath as well. But while the growth in consumer credit may decelerate, Kumar made the point that the current bout of wage inflation should continue to buoy urban consumption growth.

The really big opportunity, however, comes from investment demand. The capital expenditure to GDP ratio was around 26 per cent a couple of years ago, which is similar to the Chinese level in the early 1990s. Kumar said he expects this ratio to go up to at least 35-40 per cent. And although much will depend on the liquidity available in the banking system and on how high interest rates rise, the good news is that corporate balance sheets are still not very leveraged. What is more, incremental cash flow continues to be higher than capex and debt-equity ratios of Indian corporates are still declining.

Underleveraged balance sheets also have another advantage — of not being affected much by the rise in interest rates. Kumar believes that the rise in wage levels may hurt bottomlines more than the higher interest rates. The biggest impact on the Indian market, however, will come about if there is a change in global risk appetite. In the past three-to-four years, India has received a disproportionately high share of funds flowing into its markets as a result of high risk appetite. In short, as many analysts have pointed out, India is a high beta market. The flip side is that when the tide turns and risk aversion raises its head, markets like India get hurt badly.

Finally, in the past three years corporates in India have had the advantages of higher sales without having to do capex and while enjoying the benefits of their earlier cost-cutting measures, which resulted in profits higher than sales. That golden age is now coming to an end.