In the first of a two-part series looking at the key issues investors are asking themselves on the ASX, we explore; 1) what the CHESS 2.0 replacement program could look like; and 2) the CAPEX spending trends of the ASX vs global peers. These two issues have been interlinked over the last few years, and they are likely to remain so for at least the next 2-3 years.
Uncertainty around CHESS 2.0 program is likely to overhang the share price until late 2023 when ASX is due to update the market on its revised path forward. We see earnings risks to the downside on additional spending, and a longer time frame for implementation relative to market expectations.
Relative to global exchange peers, ASX continues to spend higher amounts on CAPEX, which has the impact of crimping free-cash-flow growth. We doubt whether ASX costs growth, which has been well ahead of revenue growth in recent years is likely to change over 2023/24.
Updates on CHESS 2.0 will come in two forms this year. Firstly, the ASX Strategy Day 6 June, which is likely to outline the broad perspectives and principles that CHESS 2.0 will have, followed by 4Q 2023 formal update on the CHESS 2.0 program. This should contain guidance on costs, vendors, timeframes.
Investment View
We rate the ASX a Hold. ASX’s earnings multiple has de-rated by a third since the beginning of 2022. Despite the improved valuation appeal, ASX trades at a premium to global peers whilst offering mid-single digit earnings growth, well below the growth of global exchange rate peers.
Uncertainty around the regulatory environment and ASX’s free-cash flow profile leave the ASX with an unusually high-level earnings risk.
We see limited ability for the ASX to be part of any potential global exchange consolidation, given the ‘national icon’ status view from Australian regulators.
A positive stance on the ASX would require; 1) evidence of improved Futures volumes from currently depressed levels (20% of revenue); 2) a refreshed, credible CHESS 2.0 program; 3) clarity on regulatory and structural separation concerns; and 4) improvement in volumes – particularly IPO activity.
Key Issue 1 | CHESS Replacement Program
In late November 2022, the ASX announced that it will reassess all aspects of its CHESS replacement project. As a result, the ASX will incurred a A$245m-A$255m (A$172-A$179m after tax) write down charge at the 1H23 Results. From a financial perspective, the work done since 2018 has been written down to zero.
The project was expected to replace the current CHESS clearings and settlements system (which is approaching 30 years old) with an innovative Distributed Ledger Technology (DLT). The failure of the CHESS replacement program means a revised project scope needs to be created, tested with the market regulators, costed, and then implemented. This could be a 3–5-year process.
The four regulators who govern the ASX are acutely focused on ASX’s ability to deliver on key projects given the importance of CHESS to financial system and lack of delivery in recent years.
There remains a risk regulator see the CHESS failure through very large lens, viewing the ASX as being too large and unwieldy to manage.
A forced structural separation of the clearing and settlements function of the ASX is potential solution. This would be clear negative to both earnings (~20% of revenue at risk), and the earnings multiple applied to the ASX. Globally, there is little precedent for separation, with all large exchanges we track being integrated across trading and settlements.
The ASX has until the end of 2023 to come up with a CHESS 2.0 replacement plan. We see two broad options;
- Option 1 – salvage aspects of old project.
- Option 2 – complete project rebuild.
We estimate market consensus is currently factoring in $30-40m pa of additional CAPEX per year out to 2025E for the revised CHESS replacement program. It remains unclear if any of the prior work can be salvaged for the revised CHESS replacement program.
A completely new CHESS replacement project could come at cost of ~$60m pa for up to 5 years. A significant costs increase should not come as surprise given the ASX operating cost growth has been running at 8% pa since 2017.
We remain of the view that ASX will need to develop a bespoke solution, and that an adaptation of an off-the-shelf solution will not suffice.
In our view, Option 2 is the most likely path that the ASX will follow. The ASX is currently designing, scoping, and tendering out elements of the project with ASX due to inform the market in 2QFY24 what its plans are.
Figure 4: ASX CHESS 2.0 decision tree
Figure 5: ASX CHESS replacement - key strategic questions for investors
Key Issue 2 | CAPEX Spending Remains Elevated
Capital expenditure at ASX has remined elevated for number of years. Since 2018, CAPEX spending has grown at an annual rate of >20% pa.
Relative to global peers, ASX is spending almost twice as much (% of revenue measure) on CAPEX. To-date, there remains little evidence that new sources of revenue growth or a lowering of operating costs has been found.
Figure 6: ASX capex to revenue has been double that of global peers, and is expected to remain elevated over the next three years.
High levels of CAPEX growth are also being matched by elevated levels of cost growth. In FY23, the ASX is guiding to 10-12% expense growth including D&A charges.
Figure 7: ASX CAPEX has been rising along with cost growth. Forward estimates for both look too conservative.
A key outcome of the CHESS 2.0 program will be whether it allows for structural lowering of the ASX costs base through efficiency gains. We see cost leverage as the key benefit the ASX rather than opening new avenues of revenue growth. Since 2015 ASX cost growth has on average been higher than its revenue growth. This has resulted in the ASX’s EBITDA margin falling from 77% to 67%.
Risks to Investment View
