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Morningstar | Two Become One: Japan Exchange Group Reaches Basic Agreement With Tokyo Commodity Exchange. See Updated Analyst Note from 28 Mar 2019

Japan Exchange Group reached a basic agreement to acquire the Tokyo Commodity Exchange, and we view this as a strategic positive. The merger was long awaited, and we have long argued the integration of Tokyo Commodity Exchange makes strategic sense, allowing Japan Exchange to broaden its portfolio of derivatives products. Japan Exchange’s existing derivatives largely consist of equity-related contracts in the domestic Nikkei and TOPIX indexes, and a futures contract on 10-year Japanese Government Bond. From an earning perspective, the additional asset classes will provide diversification and reduce dependency on the equity market. The combination of the two separate clearinghouses should result in cost savings for market participants if clearing and maintenance margin can be better utilised and applied across multiple asset classes. Our fair value estimate is unchanged and capital expenditure is increased to JPY 45 billion over the next three years, in line with the updated guidance in the exchange’s third Medium-Term Management Plan, which was also announced today. The financial impact of the Tokyo Commodity Exchange acquisition is minimal. Tokyo Commodity Exchange was loss making in the last fiscal year with revenue of JPY 3.1 billion, compared with JPY 120.7 billion in fiscal 2017 for Japan Exchange. Listed commodities exchanges, or financial exchanges with commodities derivatives, are trading on enterprise value to EBITDA multiple between 15 to 20 times. In addition to corporate cash, we estimate the implied equity value of JPY 8 billion to JPY 9.4 billion for Tokyo Commodity Exchange without a control premium.

The intention to form a unified exchange was a key initiative in the amendment of the Financial Instruments and Exchange Act in 2012. The amendment paved the way for the merger of Tokyo Stock Exchange and Osaka Stock Exchange, to form Japan Exchange Group in 2013. However, there was no change in the regulation of commodity derivatives, which was governed by the Commodity Derivatives Act. Regulation of Tokyo Commodity Exchange remained with the Ministry of Economy, Trade and Industry and the Ministry of Agriculture, Forestry and Fisheries of Japan, depending on the underlying commodities of the contract. Timeline for the current deal will see due diligence lasting until late June with a final agreement and tender offer by the end of June. The integration of the two exchanges and clearinghouses are expected by fiscal 2020.

There were no surprises in the third Medium-Term Management Plan, and our long-term thesis is unchanged. Besides the new initiative of integrating Tokyo Commodity Exchange if the acquisition is successful, the focus is on the implementation of new trading platforms and the improvement of system infrastructure. The latter involves the development of a backup data centre in Kansai and was previously announced. Return on equity target of 10% in any market condition was reiterated, and we continue to forecast return on equity to average 16% over the next five years. Likewise, average return on invested capital of 41% far exceeds its weighted average cost of capital of 6.8%, reaffirming our wide economic moat rating. A dividend payout ratio of 60% was also reaffirmed.