BSE IPO: Makes sense

BSE (formerly Bombay Stock Exchange), Asia’s oldest stock exchange, is making an initial public offer. At the upper-end of the price band of ₹805-806, investors in the exchange will be selling shares worth ₹1,243.4 crore by offloading 1.54 crore shares, representing 28.26 per cent of the outstanding shares. Singapore Exchange and Quantum Mauritius are exiting fully. The shares will be listed on rival NSE’s platform as SEBI doesn’t allow self-listing. On estimated earnings for 2017-18, BSE is asking for a valuation of around 17 times (based on profits post-divestment in CDSL) at the higher end of the price band.

Global exchanges, including NASDAQ, Intercontinental Exchange, SGX and CME trade at 15-22 times. So, the asking price is not expensive. MCX, the only other listed bourse in the domestic market, trades at about 31 times its likely earnings of 2017-18. It is, however, not right to compare BSE with MCX as the latter is the leader in the commodity derivatives market. MCX’s valuation has also been distorted by a sharp drop in earnings over the past year.

BSE is cash rich. One-third of its income comes from earnings in investments and deposits. Over the next few months, the exchange will receive an additional ₹200-250 crore when its sells stake in CDSL. The exchange has to reduce its stake in the depository to 24 per cent from 50 per cent in line with SEBI regulation.

However, only investors with high risk appetite and willing to stay put for two-three years should bet on this IPO. In equity cash, as well as in equity derivatives, BSE has very little market share. Other segments — currency derivatives, bonds and mutual funds trading platform and the SME board — hold relatively more promise. But it needs to be seen if BSE will be able to convert this potential into revenue.

Also, given that exchanges face regulatory risk, their stocks are not a good bet for small investors who can’t withstand price volatility.

BSE has four sources of income — securities services (income from transaction charges and clearing and settlement of funds), services to corporates (income from listing charges), fees collected from selling data and, lastly, income from investments and deposits. Investment income contributes 30 per cent of the total income. Of the balance, 40 per cent comes from securities services (where half the contribution is from depository services of CDSL).

In the last five years, BSE’s revenue has grown at a compounded annual rate of 5.8 per cent. Growth in profits was at a lower 4 per cent. In 2015-16, total income was ₹658 crore and net profit ₹122.5 crore. The sluggish performance is explained by the loss in market share.

In the equity cash segment, BSE’s market share stands at 13.7 per cent now, down from 19 per cent in 2011-12. In equity derivatives segment too, the exchange has negligible volumes. Between 2011-12 and 2014-15, equity derivatives volume on the BSE increased, thanks to the liquidity enhancement initiative (where the exchange incentivised its members to transact on its platform), but in the last two years, after discontinuation of the scheme, volumes have fallen to where they were initially and the market share is under 1 per cent now.

In currency derivatives, the exchange has been faring well. The average daily turnover on the segment is now ₹13,000 crore compared to NSE’s ₹20,000 crore. Revenue contribution through transaction charges from this segment is also set to go up as the exchange has indicated it will be revising its charges up to ₹20/crore of turnover in the next few months from the current ₹12/crore (was ₹10/crore in October). Given that NSE’s charges are way higher (₹110/crore) in the currency derivatives segment, there is enough room for BSE to improve its revenue here.

BSE’s other segments — interest rate futures, mutual fund trading platform and the SME board — are still nascent. The international exchange set up in GIFT city, will also take time to generate revenues.

Income from depository services of CDSL will reduce in 2017-18 as BSE will divest its stake in the entity (CDSL contributes 20 per cent to revenue and 30 per cent to net profit). Growth drivers next year will thus, be the income from higher transaction charges in currency derivatives and increased volumes in the equity segment if equity penetration increases.

In the first six months of 2016-17, BSE has grown its revenue by 26.6 per cent compared with the same period last year. This is thanks to increase in transaction charges for illiquid scrips and increase in income from depository services of CDSL. Profit margin at the operating level increased to 50.4 per cent from 45.7 per cent.

Margin at the net level was also higher as the liquidity enhancement programme was discontinued from April 1. Profitability may improve in the coming year, as SEBI has exempted stock exchanges from transferring 25 per cent of profits to the Settlement Guarantee Fund (SGF) of clearing corporations.