In the second of a two-part series looking at the key issues investors are asking; we explore; 1) when will earnings growth accelerate; 2) new areas of earnings; and 3) recent leadership changes for ASX.
The slow-down in ASX’s EPS growth since its peak in 2018 has been accompanied by a 30% decline in the PER multiple from 35x in 2021, to a forward PER of 25x today. The ASX still commands a PER premium to the market of 1.7x, in line with its average since 2019.
The 85% collapse in Listings activity (~25% Revenue) data over the last year, along with a fall in Futures Markets activity (~25% Revenue) has weighed on the ASX share price and PER multiple.
Lower levels of activity should normalise once market participants are more comfortable with the interest rate outlook. Just how quickly earnings can rebound is closely tied to ASX’s cost base, which has been growing faster for over a decade.
Investor uncertainty regarding the near-term earnings direction of the ASX has been intensified by recent changes in leadership at both the Board and Executive levels. The replacement of the Chairman and CEO in 2021 and 2022, primarily due to the CHESS replacement failure, has contributed to this uncertainty. Despite this, CHESS project leads are still holding leadership roles at ASX.
CEO Helen Lofthouse can potentially reshape investor expectations at the ASX Strategy Day on June 6, 2023. The first event of its type in several years.
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 (25% 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 3 | When Will Earnings Growth Accelerate?
Over the last 5 years, the ASX has grown EPS by 3% CAGR, which is close to half the growth rate of key regional exchange peers Singapore and Hong Kong. Consensus has the same level of growth forecast into FY25E, which is well below regional peers at 8%.
The lack of earnings growth is seeing the PER multiple de-rate for the ASX. The twin issues of soft growth and strategic uncertainty continue to weigh on ASX.
Futures and OTC clearing is around 25% of ASX revenue and has been declining for two years. It remains unclear as to when revenue growth will return. The large amount of government debt issuance in FY20 likely assisted revenue growth as participants (banks, corporates, and financial market participants including hedge funds and proprietary traders) looked to hedge interest rate exposures.
The subsequent RBA yield curve control program from 2020-2022, which shocked markets by anchoring long-term bond yields reduced the need requirement to hedge long-term rates, whilst many proprietary trades reduced participation altogether. The ASX itself remains unclear on when clients will sustainably return, and revenue growth in this division will accelerate. It is worth noting that Futures and OTC volumes have improved (off low levels) through Dec 22-Mar 23. Perhaps reflecting higher interest rate volatility seen in 2023, and Financial Market participants seeing more need to interest rate hedge.
The other area of revenue pressure is capital-raising revenue. Both IPO and secondary raising revenue have been under pressure over the last 12 months as the global equity market has re-priced risk.
It’s likely that higher interest rates locally will continue to be a dampener on capital raisings. The ease of equity capital raising for unprofitable growth companies is unlikely to return even when official cash rates peak domestically in mid-2023 (Sandstone Insights view), which generated significant activity for the ASX in recent years.
A burst of capital raisings as interest rates pause/peak in mid-2023 is possible given pent-up demand, and the requirement for capital for some companies. Under this scenario, the ASX share price could potentially face upward pressure as investors anticipate improved revenue momentum.
Figure 8: Futures and OTC revenue has decline for two years straight
Figure 9: Showing signs of life. Futures and OTC activity has rebounded in CYTD 2023.
Figure 10: Australian IPO volumes remain soft, and may accelerate until 2024
Key Issue 4 | Futures and OTC Revenue Has Decline For Two Years Straight
Over the past five years, ASX has had limited product development and new revenue initiatives due to the substantial amount of physical and intellectual resources consumed by the CHESS replacement program.
Under Lofthouse's leadership, ASX is currently exploring a new strategic roadmap. An update is expected to be provided at the ASX Strategy Day on 6 June 2023, which will be the first in several years.
Figure 10: ASX is in process of refining their strategic roadmap.
In our opinion, ASX needs to refocus on its core purpose and prioritize the delivery of its core infrastructure improvements, including CHESS 2.0. The previous development of the CHESS replacement system placed significant pressure on ASX's clients, with client development costs estimated to be as high as the total cost to ASX ~$250m. The recent allocation of $70m for clients as the company embarks on CHESS 2.0 reflects that the ASX lost its client focus. Rebuilding client relationships and trust is necessary to open new revenue opportunities. Even for a monopolist like the ASX.
ASX's strategic gaps in client offerings relative to global exchanges are relatively minor, and it has one of the most balanced revenue mixes among major global exchanges. The ASX is likely to pursue only incremental revenue initiatives in our view.
One area that could see additional investment is the Information Services division, which represents 13% of ASX's revenue and has been the fastest-growing division for the past five years. Scaling up and enhancing the services offered here could further accelerate revenue growth.
This may require additional investment or even M&A, particularly if ASX wants to provide "value-added" data services. Before the 2000s, ASX had a more complete and serious value-added data service offering but has subsequently exited those businesses.
In 2021, the London Stock Exchange (LSEG.UK) acquired global markets information provider Refinitiv for $US27bn to add institutional-level value-added services. This was an aggressive adjacent acquisition for the LSE done in part to fend off a proposed takeover from the Hong Kong Stock Exchange (0388.HK).
In our view, ASX is unlikely to move too far away from its core business in any M&A play, especially with the new leadership team in place and CHESS 2.0 being the key strategic priority to get right. The Group in our view does not have the backing from investors to undertake large-scale M&A at present.
Nonetheless, it is worth noting that IRESS (IRE.AX), the local version of Refinitiv, has lost ~25% of its value in the last 12 months. With a market capitalization of $1.9bn compared to ASX's $13.0bn, an acquisition of IRESS would provide ASX with greater scale in data and information systems while deepening its relationship with many of its customers. However, there would likely be client pushback, with IRESS also considered a "virtual monopoly" by many market participants/users. Competition concerns with the ACCC could also be a potential sticking point. Both businesses are under new leadership teams and require a strategic refresh and repurposing in our view.
Key Issue 5 | ASX Leadership Changes
Over the past year, there have been several notable changes to key leadership roles within ASX. The changes occurred post the retirement of former Chairman Rick Holliday-Smith (2012-2021), and are notable for two reasons.
- the extent of the changes (the ASX historically has had a very stable leadership group) and;
- we believe that the failure of the CHESS replacement program had a significant bearing on the timing of many of the changes.
New CEO, Helen Lofthouse, assumed her position in August 2022, whilst newly appointed CFO Andrew Tobin has been in the role for just 8 months. Both Lofthouse and Tobin were external appointments to the ASX. The role of Deputy CEO was abandoned in 2021 following the departure of long-standing Deputy Peter Hiom.
In our view, further changes are needed to complete the refresh of the management team and to lift accountability within the ASX for failed $250m CHESS replacement project. This would also provide an opportunity for a fresh strategic lens on how ASX is going to position itself going forward.
We would highlight three key executives which had overall oversight for the failed CHESS program and currently remain with ASX in senior leadership positions.
- Tim Hogben (Group Executive, 23 years ASX). Hogben ran the CHESS replacement program. On several occasions told regulators/market participants that the program was 95% complete.
- Dan Chesterman (Group Executive, Technology and Data, Chief Information Officer, 6 years ASX), responsible for ASX’s overall technology strategy under the prior CHESS replacement program.
- Hamish Treleaven (Chief Risk Officer, 6 years at ASX) is responsible for overseeing all aspects of operating risk for the Group, including CHESS replacement. Treleaven was appointed in 2017 following prior governance failures, which resulted in ASIC reviewing the Group’s technology and risk governance in 2018.
Given the ongoing challenges presented by the CHESS 2.0 replacement project, obstacles may arise for the new leadership team to achieve substantial change, given key technology executives remain in the Group.
In our view, investors would welcome a refreshed technology team, particularly with people with significant experience in complicated technology projects. This would complete the process of change that began with the departure of the former Chairman in 2021.
Board Changes
Damian Roche was promoted to Chairman in 2021, having served on the Board since 2014, following the departure of former Chairman, Rick Holliday-Smith (2012-2021). Roche was part of the Board that signed off on the CHESS replacement project in 2016.
Since 2021, there have been four Board changes, resulting in a Board with nine vs eleven members prior. Seven Board members currently have ASX shareholdings, which have combined value equating to two years of directors’ fees.
Whilst investors are frustrated with multiple failure points of the CHESS program and the lack of accountability, investors should not understate the significant challenge the introduction of a blockchain-based platform entails for an organisation. This technology is commercially unproven at scale. In the shipping industry, A.P. Moeller-Maersk A/S (MAERSKb.CO) and IBM (IBM) last year announced the end of the development of a blockchain-enabled global shipping platform.
Separately, ASIC has announced (29 March 2023) an investigation into potential breaches of the Corporations Act (2001) around continuous disclosure obligations around CHESS replacement updates from the ASX. In our view, this underscores just how poor the execution was on CHESS replacement and suggests that the level of scrutiny on CHESS 2.0 will be significant.
Figure 11: ASX CEO fixed pay is below the average pay of an ASX Top 25 company
Management Incentives
In our view, the ASX should provide best practice leadership and help set the standard on remuneration and management incentives given its role as the primary exchange in Australia.
To understand the likely behaviour and strategy of management, one effective approach is to examine the level of base or fixed pay of the CEO. Lower base pay tends to lend itself to a greater likelihood of long-term shareholder value creation.
Lofthouse's fixed remuneration of $2m per year is not materially different from the average CEO base pay of the top 25 ASX CEOs. The ASX currently ranks ~40 in the ASX 100 highest paid CEOs.
Upside incentives can be up to 200% of fixed pay, and the total package size is the same as that of the former CEO. However, the ASX does not disclose the hurdles that Lofthouse needs to meet to receive upside incentives, which was also the case with the former CEO.
We believe that greater transparency is necessary regarding the measures and hurdles that must be met to unlock upside incentives, especially regarding capital expenditure and return profiles.
Risks to Investment View
