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Morningstar | A New Hope: Wide-Moat Japan Exchange Group and Tokyo Commodity Exchange Open to Merger Discussion

A recent media report stated that Japan Exchange Group, or JPX, and Tokyo Commodity Exchange, or TOCOM, are in discussions on a possible merger. The merger has been discussed since a change in legislation in 2012, and as we highlighted in a note in 2017, "Japan Exchanges Visit: Liberalization of Energy Markets an Opportunity for Derivatives Market," we believe the consolidation of the two exchanges makes strategic sense. The main hurdle, as highlighted at the time, was more political, given the separate regulatory entities: TOCOM is regulated by the Ministry of Economy, Trade and Industry and the Ministry of Agriculture, Forestry and Fisheries, while Japan Exchange Group is regulated by the Financial Services Agency. As stated in the media report, the discussion appears to be government-led.

Our wide moat rating is unchanged, and we believe the deal will strengthen JPX’s competitive position. In contrast to regulators in the West, we do not expect deregulation of exchanges and clearinghouses to occur in Asia and negatively affect the Asian exchanges under our coverage. JPX’s share price has declined 7.4% over the past month and underperformed relative to the market, with shares now trading largely in line with our unchanged fair value estimate. We do not see a fundamental reason for the underperformance, with daily equity trading volume 4.2% higher against the year-ago period. Derivatives volume also benefited from higher volatility. There is speculation in the market since August that the Bank of Japan, or BoJ, is scaling back its monetary policy and reducing its ETF-buying programme. As previously highlighted, we believe the unwinding of BoJ’s position should provide a temporarily uplift in trading volume. However, this is volume-related, and we reiterate our view that investors should focus on the competitive advantage of the exchange. The exchange will release its second-quarter result next Monday (Oct. 29).

The exchanges have an existing relationship, with TOCOM using JPX’s trading and clearing system. As such, there should be some cost savings if a consolidation does proceed. However, the financial savings are minimal in the context of the combined group, and we see this as a minor reason for the merger. Rather, the key is the strategic benefit in increasing the competitive of JPX, along with the overall commodities and energy derivatives market in Japan. According to the U.S. Department of Energy, Japan is one of the top five consumers of energy at 5% of the world’s energy consumption, particularly in natural gas and crude oil. One opportunity is in LNG, as spot indexes in Asia have low levels of liquidity as prices are negotiated bilaterally. Still, the development may be some time away.

While the scale of this consolidation is much smaller than Hong Kong Exchange and Clearing’s acquisition of the London Metal Exchange, given that prices for the latter’s contracts are global benchmarks, we believe there are several benefits for JPX. The consolidation would broaden JPX’s portfolio of derivatives products, which largely consist of equity-related contracts in the domestic Nikkei and TOPIX indexes and a futures contract on 10-year Japanese government bonds. The addition of commodities contracts, a separate asset class from equities, will provide diversification to JPX, as commodities usually have a negative correlation to equities. TOCOM’s more popular derivatives contracts include precious metal contracts in gold and platinum, energy contracts in crude oil, and materials contracts in rubber. TOCOM’s derivatives contacts are cleared through its own clearinghouse, and consolidation of the two clearinghouses would also provide cost savings for market participants, as their clearing and maintenance margins can be better utilised and applied across multiple open positions of different asset classes. We believe moat traits in switching costs will be enhanced for JPX in this case.

While the media report stated that both exchanges are considering a leading role in the consolidated entity, JPX’s larger size and profitability, relative to TOCOM’s smaller and loss-making operation, mean that the former is likely to emerge as the lead in the merged entity. TOCOM’s total assets of JPY 136.1 billion and revenue of JPY 3 billion are significantly smaller than JPX’s total assets of JPY 41.3 trillion and revenue of JPY 120.7 billion.
Listed exchanges globally are trading on enterprise value/EBITDA multiples of 13-23 times. Assuming corporate-level cash and excluding members margin at TOCOM, we estimate equity value ranging from JPY 7.6 billion to JPY 10.1 billion, excluding a control premium.