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Morningstar | Strong Fiscal 2018 Performance Unlikely to Be Sustained by ASX

Wide-moat-rated ASX’s fiscal 2018 result was a little stronger than we expected, with the 8% revenue growth rate ahead of our 6% forecast. We have increased our fair value estimate by 2% to AUD 49 per share; this mainly reflects an increase to our revenue forecasts for the information and technical services businesses, which are tracking ahead of our expectations. However, at the current market price of around AUD 68, we still believe the shares are overvalued.

The key driver of the strong result was the listing and issuer services division, which comprises 26% of group revenue and increased revenue by 15%, ahead of our 9% forecast. The main reason for the strong performance was a 46% increase in capital raisings versus the prior year, reflecting bouyant market conditions. However, we don’t believe the current cyclical strength in capital markets reflects a structural growth trend for ASX, and we still forecast mid-single-digit revenue and underlying EBITDA CAGR over the next decade. The fiscal 2018 underlying EPS growth of 7% was higher than our 5% forecast, but statutory EPS grew by just 2% due to the impairment of the investment in Yieldbroker.

The market price and our earnings forecast imply a price/earnings ratio of 27 versus 19 at our fair value estimate. One of the reasons for our bearish view on ASX over the past couple of years is that we don’t believe the share price rise has been supported by a sustainable improvement in the EPS growth outlook. In this regard, the one-year forward P/E ratio has steadily increased from around 15 at the start of 2013 to around 27 currently. This increase seems inconsistent with the lack of improvement in the EPS growth outlook and the increasing likelihood of interest-rate rises, which arguably justifies a lower rather than higher multiple.

The key challenge facing ASX is to increase its earnings growth prospects beyond the mid-single-digit EPS growth generated by its Australian listed securities businesses. In this regard, management discussed the potential of its distributed ledger technology, or DLT, which will replace the Clearing House Electronic Sub Register System, or CHESS. Management believes the DLT system has the potential to create new revenue streams, but the project still has many hoops to jump through and no details have been provided regarding potential monetisation of the technology. At minimum, however, we expect the company to maintain its existing clearing and settlement revenue, which combined comprise around 12% of group revenue. We await further progress with the project before potentially incorporating more upside to our revenue forecasts.

Management highlighted the progress being made with new listings, particularly of overseas technology stocks. Xero, a technology company that recently switched its main listing from the New Zealand Stock Exchange to ASX, was cited as a particularly successful example of this. However, we still expect most new technology company listings on the ASX to be relatively small and speculative, and we anticipate that the main source of new listings will remain Australian companies, with a skew towards the resources sector. We also see the ASX as more vulnerable to losing listings to overseas exchanges than attracting listings from them, in part due to the relatively small size of the technology sector in Australia. In Xero’s case, the company was already dual-listed on the ASX and could yet move to a U.S. exchange, as it has previously considered.

Beyond ASX’s listings division, the information and technical services businesses, which comprises 20% of group revenue, also performed well, delivering revenue growth of 9.7%, but in line with our 10% forecast. However, the growth in these businesses was driven by factors such as demand for the Australian Liquidity Centre, which looks relatively sustainable. We also increasingly believe that ASX’s network effect means its customers are a reasonably captive audience for these services, and we now forecast revenue CAGR of 6% over the next decade, up from 5% previously.

The cash-equities-related businesses--including cash equities trading, cash equities clearing, and cash equities settlement--delivered flat revenue growth that was a little weaker than our 2% forecast and reflected a drop in trading activity and competition form block trading. However, we believe this largely reflects the cyclical nature of the company, and as with the listings business, we expect the weak growth from cash equities to return to mid-single-digit growth from fiscal 2019.

From a balance sheet perspective, ASX remains bulletproof with no debt, AUD 8.5 billion in participants margin commitments, and AUD 1.1 billion in ASX-owned cash, of which AUD 226 million is free to use. Although expenses growth and capital expenditures will increase in fiscal 2019, we are extremely comfortable regarding the sustainability of fully franked dividends.