I want to find businesses which get better with time like aged whisky. These are businesses which have a competitive advantage which is not only sustainable but grows over time. And that led me to the concept of businesses for which time is a friend. Businesses go through cycles and however strong the business may be, it will face its share of difficult times. These could be due to an external reason such as industry or economy-wide slowdown or due to internal reasons specific to the business. Most business struggle to survive during these so called downcycles. But are there businesses which handle the adversity well and emerge stronger with each downcycle? The laws of probability will ensure that the former business will eventually collapse while the latter will thrive. And these are the businesses for which time is indeed a friend.
This ties in with the concept of anti-fragile from the book of the same title by Nassim Nicholas Taleb. He defines anti-fragile as something which gains from disorder. Normally objects or companies don’t like volatility and disorder. However, there is a scale along which we can rank companies in their tolerance for adversity. For example, in case of a recession, there are sectors of the economy which are affected disproportionately such as infrastructure, real estate, capital goods etc. Companies belonging to these sectors are affected negatively and some of them may not make it out of the recession. Moving along, there are companies in sectors such as consumer goods which are negatively affected but to a lesser extent. Further along come companies which provide essential services such as hospitals, schools etc. The demand for these services holds up quite well even during recessionary times. And finally, at the other extreme are companies which are anti-fragile. Which actively like volatility and recession and disorder. Which are these companies?
In his book, Taleb describes a few characteristics of the things which are anti-fragile. Some of these qualities are: 1) Redundancy / Slack, 2) Optionality, 3) Non-linearity. We will come back to this later in the article.
One such company is Multi Commodity Exchange (MCX). MCX, which commenced operations in Nov 2003, is the largest commodity exchange in India and is a virtual monopoly. Their market share in Bullion, Energy and Base Metals is close to 100% and this accounts for ~98% of their revenue. The precise market share at the end of June 2019 is: Precious metals and stones 99.68%; Energy 100.00%; Base metals 100.00%. Their stated intention is to sustain their dominant market share in these commodities. In addition, they have ~16.31% market share in agri-commodities. Here their strategy is not to go after market share but play in niche areas where they have an advantage over the competition.
In terms of the business of the company:
- Financial exchanges are generally dominant winner-takes-all businesses. This is because of the network effects which are an inherent part of such businesses. This applies to all exchanges as exchanges are where buyers and sellers congregate to transact. The more buyers and sellers there are on a particular exchange, the more of them it attracts leading to a virtuous cycle. This is especially true of commodity exchanges as commodity exchanges includes a variety of participants including corporates, traders and investors. Hence over a period of time, their competitive advantage or moat increases.
- But what happens in times of stress or disorder. MCX has been subject to a high level or disorder, both internal as well as external.
- External: Commodity Transaction Tax (CTT) was imposed in July 2013, which reduced the volumes on MCX (and more broadly for the entire industry) by ~40%!
- Internal: Crisis as a result of fraud at NSEL (which was a subsidiary of FTIL) in July 2013. FTIL which was the promoter company (and major shareholder) for MCX declared not “fit and proper” to run an exchange. After the fraud at NSEL, FTIL was forced to divest their shareholding in MCX. Currently MCX has a diversified shareholding with one major shareholder – Kotak Bank with 15% share as of FY18.
- The average daily trading volume (ADTV) at MCX declined from a peak of INR 503bn in FY2012 to INR 203bn in FY2015. Since then it has recovered to INR 225bn for FY2017 and 212bn for FY2018.
- Operating revenue declined from peak of INR 545cr in FY2012 to INR 222cr in FY2015. The revenue has gradually inched up to INR 260cr in FY2018.
- EBITDA margins have declined from 69% in FY2012 to 47% in FY2018. Net profit margins declined from 45% in FY2012 to 31% in FY2018.
- Any other company would have serious repercussions on business in such situations. But MCX has survived these twin problems with minor bruises. Market share declined to 77% post the crisis by the end of 2013 from 87% at the end of March 2013. However, despite all this MCX was able to regain its market share back quickly, which was 86% by December 2014 and reached the pre-crisis levels of above 87% by March 2015. The market share is 92.25% at the end of June 2018.
- MCX is a franchise business with a solid competitive advantage. The business has survived and returned virtually unscathed from the crises described above.
Let’s take a look at the detailed financials over the past few years before we delve deeper into the business. Find below a summary of their financials, including P&L, B/S and Cash Flow Statements.
Figure 1: Brief Financials
|Total operating income||287||369||545||524||340||222||235||260||260|
|PBT (before exc items)||323||246||410||406||209||170||167||178||148|
- The other income forms a significant part of the total income. This is the investment income from the cash and other investments. The company had sizeable cash and equivalent investments of INR 1,400cr at the end of FY 2018. In FY2018, the company had other income of INR 92cr out of total income of INR 352cr.
- The business is reasonably profitable. However, this is not apparent from the above table as it shows a return on equity of modest 8%. This is because the assets also include cash and cash equivalents of ~INR 1,400cr. This has artificially depressed the ROE of the core business.
- Over the last 8 years, the company generated total cash of INR 1,287cr (cash flow from operations of INR 840cr and cash flow from interest on investments of INR 447cr.) Out of this they spent INR 192cr on capex leaving them an excess cash of INR 1,095cr. The company gave its shareholders dividend of INR 615cr, leaving them with excess cash of INR 480cr.
- Because the company is profitable and does not require too much money to be invested in the business, they do not require any external sources of funding either in the form of debt or equity. That is why the company has zero debt and zero equity issuance during this period.
- Dividend yield is currently 1% but there is room for substantial increase in dividend going forward.
Finally, lets take a look at how the business stacks up on the three anti-fragile criteria discussed earlier.
- Redundancy / Slack – the business is debt free and has substantial cash and equivalents. The nature of the business is such that the capex requirements can be easily met by the cash generated from operations. The excess cash can be returned to the shareholders or can be used for inorganic growth. Hence there is redundancy or slack in the form of excess cash on the balance sheet for which there is no apparent use. However, if an opportunity were to present itself for inorganic growth, the company can move quickly.
- Optionality: This means that the business has the option to explore multiple opportunities or growth avenues. And the cost of exploring these growth avenues is small so that failure in any one of them does not jeopardize the business. The company has optionality in the form of the following:
- New products: so far only futures were allowed to be traded on the commodity exchanges in India. SEBI allowed introduction of options and MCX has launched the first option in gold in October 2017. They will launch the full set of options products by the end of March 2019. The regulator has indicated that they will next turn to indices. Next will be products related to weather and freight derivatives. Additionally, MCX will also introduce more metals on the platform by FY2019. They have also expressed their intention to enter into currency derivatives.
- New participants: Currently the regulations do not allow institutional investors to participate in commodity investing. SEBI allowed participation by Alternative Investment Funds (AIF) and the fist AIF traded on MCX in September 2017. It is expected that the regulator will also allow participation by MFs and PMS in commodities which will be a big boost for MCX. White paper on this is out in Q3 2018. Next will be banks and insurance companies. As the range of products and participation on MCX increases, so will liquidity which will in turn attract more participation and volumes. This could lead to exponential increase in volumes in the future.
- Distribution: In Q3, RBI allowed Bank subsidiaries to become members of commodity exchanges. Axis Securities and a few others are in the process of becoming members. This presents a big opportunity for MCX to bump up their distribution.
- Increase in Volatility: the volatility has been quite subdued in the commodity markets during the last few years especially base and precious metals. Any increase in volatility will lead to an increase in volume and hence revenue for MCX.
- Non-linearity: this means that the for the business, the upside from success in a new initiative is more than the downside from failure. In case of MCX, it will explore new avenues for growth through new products, new participants and wider distribution. The downside from any of these not working is small. But the potential upside is high due to the nature of the business which becomes stronger as the participation and the products on the platform increase.
- MCX has a new board which has been put in place after the NSEL crisis. After the crisis, most of the board members were bureaucrats to facilitate smooth functioning of MCX during a difficult time. However, after things settled, the board has been overhauled. Currently, the board consists of two executive directors, 5 representatives from shareholders and 7 independent directors. Out of these 7 independent directors, 4 are bureaucrats, 2 are industry people and one academician.
- The management team has also undergone a change with a new CEO, CTO, and CFO.
What can go wrong
- Competition from established equity exchanges – SEBI has recently allowed universal exchanges, which means established exchanges can begin offering commodity trading on their existing exchanges. BSE has disclosed their plans to get into this business. Although, my opinion is that is it very difficult for any other exchange to usurp MCX from their market domination. But we need to keep a close eye on the market share of MCX in their dominant commodities.
- Subpar Growth: growth has been lackluster in the last 4 years. But this has to do with the multiple crises the company has had to navigate. There is little doubt in my mind that volatility will spike sometime in the future again within the next 5 years. And participants and participation in commodities markets will increase. And with that growth will come back. It is difficult to estimate the timing. Hence there is uncertainty but limited risk.
- Management: For me, this is the most important parameter. In general, I prefer businesses which have a dominant shareholder who is running the show. But at MCX the shareholding is diversified with professional management. To the three anti-fragile parameters discussed above, I would add a fourth one in terms of management. A dominant shareholder can provide stability to the business over long periods of time. That is a one part which is missing from MCX at the moment and it needs to be monitored.
- Technology: in exchange business, the backbone is always technology. They will need to keep investing in their tech infrastructure to keep it relevant and updated. While there is no signal to suggest that they are falling short on that measure. But any blunder there can have serious repercussions, especially at a time when the competition is heating up.
To conclude, here we have a monopoly business which is going through a difficult period. The growth has been lackluster over the past 5 years due to external factors. But the core business remains as strong as ever and it getting stronger. Time is a friend of MCX and I expect it to be much larger and stronger 10 years from now. The business has multiple triggers or optionalities for growth but there is uncertainty as to their timing. This is one of those businesses with high uncertainty and low risk.