ASX Ltd (ASX: ASX) might seem like a boring company, but it would be a mistake to dismiss it as an investment on this basis. The company can be thought of as owning much of Australia’s financial markets infrastructure and makes most of its money in the following ways.
- By providing a service for companies to list and raise capital (19% of total revenue in 2014)
- Through execution of trades of securities listed on the ASX including clearing and settlement services (15% of total revenue in 2014)
- By providing markets to trade interest rate, equity index, agriculture and energy derivatives, including options and futures (26% of total revenue in 2014)
- By selling real-time market information, reference data and news, and providing market access (15% of total revenue in 2014)
- Revenues generated by Austraclear, which is an electronic central depository of debt securities that also provides settlement services (5% of total revenue in 2014)
- Interest income, which is earned on the company’s own cash as well as the collateral it holds on behalf of market participants (17% of total revenue in 2014)
One way that ASX is looking to grow, is by selling a larger range of products. Since new products can be sold through existing systems, most of the extra revenue earned falls straight to the bottom line. An example of this is the introduction of mFund last year, which makes it possible to trade unlisted funds.
Another growth option is to attract more international participants. ASX launched a service last year making it possible to use the Chinese Renminbi to settle transactions in its Austraclear system. The company hopes to develop a range of Renminbi denominated products in the future.
Locally, Chi-X is the only major competitor to ASX. Chi-X is backed by a consortium of global financial institutions and also operates in Japan, Canada and Brazil. It provides an alternative option for trading ASX-listed securities.
Currently, only ASX is permitted to perform clearing and settlement activities for ASX-listed securities and so Chi-X has to pay ASX for this service. However, this situation is currently under review and it is possible that ASX will lose this monopoly which would strengthen rival Chi-X.
To put the threat posed by Chi-X in context, ASX Ltd carried out 90.6% of total volume traded on the ASX in 2014. Even if regulators rule against ASX Ltd on clearing, the impact will be small because only 15% of its total revenues are from trading, clearing and settlement of ASX-listed securities.
However, the value of the market information that ASX sells, is dependent on it capturing the majority of trading on the exchange and so other parts of the business may be affected by local competition.
In July 2014, the company reduced its fees on interest rate futures and for clearing over the counter derivatives in a sign that international competition is growing. Clients of its derivative products are generally large financial institutions with multiple global options for trading such instruments.
The continued integration of global financial markets suggests that the threat of international competition will increase and so ASX may not enjoy such favourable conditions in the future.
ASX generates huge profit margins, averaging 45% over the past five years, because of its significant pricing power thanks to its monopoly position. The company may have to accept reduced margins in the future if competition grows.
Return on equity is less impressive, averaging just over 11% in the last four years. One reason for this is that ASX must hold a large cash balance to satisfy regulatory capital requirements. This also explains why interest income is such a high proportion of total revenue.
Cash generation is exceptional, and cash flows from operating and investing activities have been 13% higher than net profit after tax over the past five years. This is because the business requires little capital investment and benefits from holding large amounts of cash which belongs to market participants.
Whilst ASX is likely to suffer from rising competition over coming years, Australia’s ever-expanding pool of superannuation funds should provide strong demand for its growing range of products. It will also benefit from more companies looking to tap into these funds by listing and raising equity on the ASX.
ASX pays a healthy 4.6% dividend, but it is unclear whether the company will be able to consistently increase pay outs in future. Click the link below to find out the name of another company that pays a decent dividend and is likely to grow for years to come.