By: Steven M. Roge, CMFC
JSE Ltd. (JSEJF.PK)
Share price: R66.52*
Intrinsic value: R114
Buy below: R79
Business Description and Background
The JSE was established in 1897 and has grown to be Africa’s biggest and premier stock exchange. From a mutual association it has grown to become a listed entity and the 20th largest stock exchange in the world, as well as being voted the No. 1 stock exchange in terms of regulation by the World Federation of Exchanges (WFE) for 2010. It listed in 2006 and the share price has gained significantly since. There are 337 companies listed on its main bourse and 68 on the smaller Alt X exchange as well as two on the newly formed African Board. It is a well diversified exchange with 30 % of its income coming from equities trading while the balance comes from a healthy mix of issuer services (10%), risk management, clearing and settlement (17%), back office services (15%), equity derivatives (10%), commodity derivatives (4%), interest rate market (3%), information product sales (10%) and other income at (7%). JSE Ltd. is cash rich and is trading at below its valuation. It has evolved from and open outcry exchange to a well diversified “best of breed” in technology and a global leader in regulation.
Thesis
JSE Ltd. is the premium exchange in Africa. It has been run conservatively surviving the global financial crisis virtually unscathed. It is cash rich and has very little gearing in comparison. Management is looking at any alliances with another stock exchanges, albeit very cautiously. At the 2010 results presentation, the CEO however pointed out they they were not looking at M&A activity, but rather working together with other exchanges to provide a better product to customers. They are upgrading IT systems to bring the exchange in line with international exchange leaders, thereby increasing trading speeds by up to 400 times. This will put the JSE on the path to higher volume of trade and therefore be able to reduce transaction costs, making them more competitive. We therefore believe the exchange is on a road of positive growth and there is a lot of upside to the share. The JSE is now the dominant force in the financial services intermediary market in South Africa with a virtual monopoly. In 2009, they acquired the Bond Exchange of South Africa (BESA).
JSE Ltd. has been diversifying for a number of years from a single product equity market to a diversified exchange. It now boasts equities, commodity and currency derivatives and interest rate instruments. They also offer listing, regulation, trade, clearing and settlement and data dissemination services. The exchange is world class and investors looking to start trading in African companies would rather begin with the JSE Ltd which is extremely liquid, pushing through volumes of approximately 23.8 million trades in the 2010 year.
The JSE is run conservatively, and hence during the recent global economic financial crisis, the exchange managed to increase revenues by 9% while global exchange leaders like the New York Stock Exchange (NYX) showed decreased revenues. Operating profit increased by a total of 10%. This is due to the fact that operating costs increased by 9% due to a recruitment drive to make sure IT projects are completed on time. Software under development was impaired to the value of R33m. Lease costs relating the BESA, which was purchased by the exchange, were also included in operating expenses. Net interest earned fell by 16%, leading to a net profit increase of only 3%. Falling interest rates would have caused this fall in net profit.
The JSE Ltd achieved return on equity of 21.1% and return on capital of 19.27% all way above it’s peers in the established economies of the world. They have no long term debt and a current ratio of 1.07 which covers all debt that they do have. The JSE Ltd has grown its revenue at a rate of about 18.9% over the past five years. This would definitely be a share to have as the African economy emerges as the next growth frontier.
JSE Ltd. has pricing power with respect to the South African market. But if the JSE Ltd. is to attract more global traders, these costs must be brought down. This will be achieved when the matching service of buyers and sellers which currently happens in London through the TradeElect platform, are moved to Johannesburg onto the Millennium system in 2011. Trades will now be able to happen 400 times faster, therefore attracting day investors and increasing volumes, which can lead to reduced prices and therefore increased competitiveness.
The JSE has a balance sheet that would resemble a treasure chest of sorts. It has no long term debt and R1,046 million in cash which should cover four months of operations, cover the investor protection fund, guarantee all central order book transactions and maintain all infrastructure that is mainly IT related. The cash does however present an opportunity for more dynamic management to go out and make some acquisitions which can complement the JSE services within South Africa or abroad. Four months of operating expenses translates to about R300 million. The investor protection fund is covered by investments consolidated into the JSE Ltd. balance sheet. Central order book transactions are guaranteed by member firms deposits and bank guarantees as well as the JSE guarantee fund trust. This therefore leaves about R750million cash for IT upgrades and acquisition activity.
Management
The CEO of the JSE Ltd. is Russell Loubser, a veteran of the South African financial services industry. He has been at the helm of the JSE for past 15 years having come from RMB investment bank where he was an executive director. He has steered the JSE through demutualization to listing on the JSE. He believes in the steady growth of the exchange. While he believes in establishing appropriate alliances with global partners, he does not necessarily believe in the M &A activity gripping the industry at the moment. He is more comfortable with the kind of relationship the exchange has with the CME. He steps down at the end of 2011 and deputy Nicky Newton King will take over as CEO from January 2012. She has worked for Russell for the past eight years. Before that she was a partner with law firm Webber Wentzel attorneys and advised the JSE on various issues before joining them. She holds a Masters in corporate law from Cambridge University and has worked on advising exchanges including the JSE. We do not expect any major shift in policy when she takes over.
Together these two have managed to steer the exchange through a decade and a half of regulatory improvement and growth leading to the exchange being the gem it is today.
The CEO owns 1,000 shares directly in the JSE, a 0.0012 percentage shareholding. And Nicky Newton King, the deputy CEO, owns 3,400 which translates to a 0.0040% shareholding. Both shareholdings are insignificant and have not changed since the 2009 year end.
Shareholding
No shareholder in the JSE owns more than 15% of the issued share capital of the JSE Ltd. and only one owns more than 10%. The top three shareholders are as follows:
| Government Employees Pension Fund | 12% |
| Skagen Kon-Tiki Verdipapirfond | 7% |
| American Funds SMALLCAP World Fund | 5% |
Opportunities
The global stock exchange industry is becoming increasingly fragmented. In certain instances, companies are listed on up to six exchanges. The JSE must keep up with trends within the exchange industry. People should be able to trade from various platforms and this must be addressed by the JSE.
The JSE also has an African board. This is the board were companies operating in Africa can list. This is a growth channel as there are only two companies listed on the Africa board at the moment. It makes it much easier to raise money for expansions or projects in Africa, Taking advantage of a very liquid exchange in comparison to other African exchanges. The JSE is also collaborating with exchanges on the African continent, helping them with improving their technologies in the quest to have African exchanges moved onto electronic platforms. An example is the Namibian stock exchange which has managed to increase its average number of trades by about ten-fold since the exchange moved to the electronic platform. This opens the way for consolidation and stronger growth in the future when the other African exchanges begin to grow. The exchanges will be leveraging JSE Ltd.’s technologies. This will give the JSE better opportunities for further takeover activity in the medium to long term. The JSE Ltd has no plans of purchasing any exchanges on the African continent. However, it did try and purchase the Mauritius stock exchange but was met with regulatory approval hurdles. The CEO of the exchange, at the 2010 results presentation did however mention that they would try and pursue this acquisition in the future if the opportunity presented itself. The Mauritius stock exchange is attractive as the financial market in Mauritius is quite mature and well regulated. I am sure that once other African exchanges achieve this milestone, they will be ready targets for the JSE Ltd.
JSE Ltd. operates in a heavily regulated environment. South Africa’s Black Economic Empowerment (BEE) laws, which are in place to correct the imbalances of the past, require that companies in the financial services sector adhere to the financial sector charter. The charter states that companies in this sector should have a shareholding of at least 25% black South African shareholders. Of this percentage, 10% must be direct shareholding and 15% can be indirect shareholding. This is law and companies must strive to attain this or put in place structures and a solid plan to attain this. At the moment there are various vehicles that are in place to make sure the JSE complies with these laws. A takeover of such a company would therefore have to take this into consideration.
The securities act of South Africa dictates that no one can hold more that 15% of the JSE Ltd. directly or indirectly without the approval of the regulatory approval. While this ensures there is no one with control of the exchange, it also makes a takeover very difficult if not impossible as it also extends to more than 15% through any associate companies. This must also be taken into consideration if one is planning to take over the exchange.
Valuation
JSE Ltd. has significant cash reserves. The capital structure of JSE Ltd. is as follows:
Net cash (R1,046 million)
Market cap (R6,725 million)
Enterprise value (R6,074 million)
JSE Ltd. shares are undervalued at the moment when valued on a Trailing-Twelve-Month (TTM) basis when adjusted for cash on the balance sheet and non-cash expenses. Based on the discounted free cash flow method of valuation, the JSE Ltd. is undervalued. A low discount rate of 8% is used due to the monopolistic nature of the firm as well as a conservative track record in running the exchange. The company has a healthy balance sheet and no long term debt. The company has been run fairly conservatively and a more dynamic risk taking team would bring phenomenal growth to the firm.
P/E (TTM) 12.5x
P/S (TTM) 5.4x
P/FCF (TTM) 23.5x
EV/FCF, ex int (TTM) 21.2x
EV/FCF, ex int (YO) 21.2x
On a normalized FCF basis using R286million, JSE Ltd shares have an FCF yield of 4.25%. Take into account a 1% annualized deduction of shares through repurchases and a double digit FCF growth rate of about 20% in the next five years. Return on investment in JSE Ltd will be in the teens after the first five years.
Sales for JSE Ltd. could reach R1.850 million R2,709 million in five and 10 years, respectively, up from R1,255 million over the past 12 months. Coupled with the fact that stock exchange expenses are usually more fixed, the increased revenues will see an increase in profits as well. With a p/s multiple of 5.4, we believe the market-cap of JSE Ltd. could be around R107 in five years and R157 in 10, using a 5 p/s ratio. We think it is reasonable to expect JSE Ltd to maintain its p/s multiple as sales increase and the market continues to warm to the shares as costs will more or less remain constant with increased revenues. Based on our discounted cash flow analysis, JSE Lt.d shares are worth R114.17, or 67% higher than JSE Ltd.’s current share price.
| Years | Free Cash Flow Growth |
| 1 | 4% |
| 2 | 4% |
| 3 | 4% |
| 4 | 4% |
| 5 | 4% |
| Discount Rate | 8% |
| Dilution | 1% |
| Total per share | R114.7 |
| Multiple to Y0 FCF | 34x |
| Price % of IV | 0.6x |
| Upside/current price | 70% |
Overall we think shares of JSE Ltd. are easily worth R114, a substantial premium to today’s current market price of R66.52.
For takeover purposes, we would recommend paying the value of R114 as this exchange can do much more with additional dynamic management of its resources. Without taking anything away from management and its conservative approach, a more dynamic approach would yield more results.
We have used a low discount rate of 8% as we believe the JSE Ltd. has a virtual monopoly in South Africa. It is a growing exchange well managed, having been voted the world’s top exchange in terms of regulation by the World Federation of Exchanges. The exchange has a lot of excess cash and can afford to take on a lot of gearing. It would therefore not be prudent to use the same discount rate used on other South African financial services companies.
A second valuation method would be to use the comparison method. For the purposes of this valuation method, we will use the following transactions as examples to arrive at a decent acceptable multiple.
The latest transaction values NYSE Euronext at 8.3 times earnings before interest, taxes, depreciation and amortization, according to data compiled by Bloomberg. That compares with 9.35 times EBITDA for TMX (TMXGF.PK) and 18.35 for ASX Ltd., the Australian stock market operator being acquired by Singapore Exchange Ltd. (SPXCF.PK).
For purposes of this valuation, we will value JSE Ltd as being mid-way between the ASX and NYSE Euronext as the JSE Ltd is in an emerging market and has a lot of growth potential, while it may not be in a big enough economy such as the ASX in Australia.
The JSE ltd would be valued at an earnings multiple of 15.
This would value the JSE Ltd. at about R6,750million and R78.29 per share.
For purposes of a valuation for takeover purposes, it would be best to use the ”comparative deals” valuation method above. We would therefore recommend buying the share at a price of R75.00 for control purposes.
Risks, Opportunities and Threats
Risk: The biggest risk associated with JSE Ltd. is decrease in trading activity. Note that 30% of income comes from equity trading.
Also, legislation that will allow alternative trading platforms for JSE-listed shares would drive prices down and lead to reduced revenues.
Opportunities: JSE Board is looking at pursuing the purchasing of the Mauritius stock exchange option. This deal was scrapped when they last tried due to regulatory hurdles. With a new CEO taking over in January 2012, this may be the new energy needed to push this deal through.
Threats: Market fragmentation if another exchange were to set up in South Africa. Threat of a takeover is low as regulation makes sure this cannot happen easily.
In conclusion, JSE shares would be a buy. It is a value share with a lot of upside potential. It is a good stock for someone seeking consistent growth and intrinsic value. The exchange is well run and as a minority shareholder one would be able to get the advantage of a well run “monopoly” in South Africa. As a potential takeover target, the JSE Ltd. seems to be very well protected from this by legislation. The biggest shareholder at the end of 2010 and presently was the government pension fund (South Africa).
If one can get necessary regulatory approvals and keep the BEE shareholding intact while getting the control of the exchange, this would be a good company to takeover. There is a lot of cash that can be used to fund further IT improvement to bring it on par with the best in the world. The new owners would be able to take on some debt and drive an expansion of the business as it has a lot of good things going for it including management, catching up with bigger exchanges on IT issues and a well regulated exchange that can be trusted to guarantee trades. A more dynamic experienced outfit in world financial markets would definitely be able to use the resources of the exchange to move it to higher heights.
We must however also bear in mind that it is this conservative approach which has steered the stock exchange through the financial crisis and grown revenues by 9% while other exchanges like the New York Stock Exchange and London Stock Exchange (LDNXF.PK) have seen falling revenues.
Sources: JSE website, company filings, data provided by EDGAR Online’s I-Metrix Professional, XBRL-enabled application. TST Outsourcing contributed to this article.
Disclosure: I am long JSEJF.PK.
Additional disclosure: This discussion is for informational purposes and should not be taken as a recommendation to purchase any individual securities. Information within this discussion and investment determination of the author may change due to changes in investment strategy when warranted by changing market conditions, or if a security’s underlying fundamentals or valuation measures change. There is no guarantee that, should market conditions repeat, this security will perform in the same way in the future. There is no guarantee that the opinions expressed herein will be valid beyond the date of this presentation. There can be no assurance that the author will continue to hold this position in companies described herein, and may change any of his position at any time.We use or best efforts to obtain good data in our models, however it can’t be guaranteed that our inputs and data are correct. This is not a recommendation for readers to purchase shares in the above security without consulting your financial professional to discuss your own risk tolerance and objectives.
