MCX Limited Stock Analysis

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MCX Limited (Multi Commodity Exchange of India Ltd.) is India’s largest commodity derivatives exchange primarily dealing in non agri commodities – Gold, Silver, Crude Oil, Natural Gas, Copper, Zinc, Nickel etc.

It is perhaps a textbook Network Effects business – more participants bring in more liquidity, which further brings in even more participants, thereby perpetuating the virtual cycle.

Its market share in India in various commodities is a testimony to its network liquidity –

Commodity MS in Indian Futures % of turnover
Precious Metals and Stones 98.6% 34.7%
Energy 99.9% 45.4%
Base Metals 100% 18.7%
Agri Commodities 17.2% 1.2%
Source – Q4 FY20 Investor Presentation

MCX is a valuable case study of a business whose strengths brought their own downfall.

Past Performance of MCX Limited

Particulars (in crores) 2007 2008 2009 2010 2011 2012 2013 2014
Revenues 168 177 219 294 373 530 509 329
increase by 5% 24% 34% 27% 42% -4% -35%
EBIT 91 40 64 123 171 312 270 100
increase by -56% 59% 93% 39% 82% -13% -63%
EBIT Margins 54% 23% 29% 42% 46% 59% 53% 30%

Commencing in 2004, MCX in its infancy saw its business grow manifold. This was on account of following reasons –

  1. Low base of commodity trading in India since commodity exchanges were outlawed till 2003, post which nation wide commodity exchanges were established.
  2. This period also saw a global surge in commodity prices including bullion.
  3. Low upfront trading margins and high volatility led to high speculative behaviour among a large swathe of participants.
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Despite the exchange being the biggest in India, it was predominantly used by retail speculators and brokers in their proprietary capacity, not the hedgers or the value chain participants like airlines for crude oil who would go to CME or LME where they’d have higher liquidity, and similar sized counter parties.

Further, the regulator did not allow FIIs, AMCs or banking companies or their subsidiaries to be a part of MCX, thereby leading to the exchange being a glorified gambling parlor.

Of course, this ecosystem would have further developed over a long term (as it is developing now), but in 2013, as volumes on MCX surged (anecdotally saw 2 bankruptcies around me due to MCX betting), the government, either because of taxation, political or public good reasons, introduced CTT (Commodities Transactions Tax) at 0.01% of the sale contract value.

This increased the trading cost by 5x, reducing the exchange volumes significantly (small investors migrating to illegal trading pots and larger ones to global exchanges, which were now cheaper than MCX) –

MCX Limited - Transaction Costs Across the World
MCX Limited – Transaction Costs Across the World
Source – Spark Capital report from 2013

Along with CTT, MCX’s former promoter FTIL was embroiled in the 5,000 crore NSEL scam, which led to forced change in ownership and dark clouds over the exchange’s reputation.

Even today, it has not been able to surpass its 2013 numbers, despite volumes increasing over the years –

Particulars 2013 2014 2015 2016 2017 2018 2019 2020 2021
Revenues 509 329 212 222 259 260 300 374 391
increase by -35% -35% 5% 17% 0% 15% 25% 4%
EBIT 270 100 52 39 61 55 78 137 163
increase by -63% -48% -24% 55% -10% 42% 74% 19%
EBIT Margins 53% 30% 24% 18% 24% 21% 26% 37% 42%
PAT 299 153 126 42 127 108 146 237 225
PATM 59% 47% 59% 19% 49% 42% 49% 63% 58%
EPS 58.5 30.2 24.7 21.4 24.9 21.3 33.4 46.5 44.3
increase by -48% -18% -13% 16% -14% 57% 39% -5%

Business Drivers

Since MCX is an asset light business, income statement matters most here. The largest set of expenses here are employee costs (20-24%), technology cost (20%), depreciation (5%) and other overheads 20%).

Because this is a fixed cost variable income business, volume traded on the exchange is the single most important determinant of long term value creation for shareholders in MCX.

Volumes on a derivative exchange have many drivers –liquidity, volatility, impact cost, regulations etc. A mix of these have led to recent increase in volumes –

Particulars 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021[3]
Gold 8,014 13,585 12,198 8,056 4,879 4,823 4,512 2,755 3,334 6,809[1] 8,703
Silver 8,655 18,616 13,173 5,722 3,659 3,288 3,384 2,543 2,565 4,539 9,347
Crude Oil 5,770 8,050 9,758 5,945 4,879 6,577 5,866 5,722 8,207 12,970 2,901[5]
NG 962 1,006 2,440 2,222 1,423 877 1,579 1,484 1,282 1,556 4,512[5]
Copper 3,847 5,031 4,391 2,500 1,423 1,754 1,579 1,484 2,308 1,686 2,256
Zinc 1,603 1,509 1,464 833 1,016 1,535 2,030 3,179 3,847 1,492[4] 967
Other products 3,206 2,516 5,367 2,500 3,049 3,069 3,610 4,027 4,104 3,307 3,546
Total 32,057 50,313 48,790 27,779 20,328 21,923 22,560 21,193 25,648 32,424 32,232
Source – MCX Website. numbers in brackets represent points made below

Increasing volatility – Trading in commodities has a visible correlation with volatility since it creates larger spreads to profit from. Below is the year wise commodity wise 20 day volatility in % –

Volatility in % 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
Gold 11 15 9 19 14 14 12 9 9 13 18
Silver 20 33 16 26 21 21 20 14 14 21 38
Crude Oil 21 24 17 21 25 42 33 24 32 39 244
Copper 19 21 13 17 17 20 19 17 18 13 20
Zinc 26 20 13 16 17 25 24 22 23 16 20
Source: MCX Website

Bold marked numbers represent semblance of correlation. Of course, in many cases this correlation does not work since multiple forces are at play.

Below are some of the other imp interventions –

  1. In Mar 2018, RBI mandated bullion traders to hedge their bullion, gems and precious stones exposure in India only, which brought significant bullion volumes back to the exchange.
  2. Introduction of option contracts along with futures and options on index (currently 2 indexes – bullion and metal). Further, there are new products in the offing like Electricity F&O. Although revenues from options and index are less than 5% fir FY21, the same can increase significantly going forward.
  3. compulsory delivery in bullion and base metal contracts if the contracts remain open at expiry (Negative point).
  4. More than 100% margins were imposed in crude oil contracts by SEBI on account of extremely high volatility in April 2020, leading to traders unable to profit sufficiently from wide fluctuations and declining volumes on the exchange for the entire year. Some of the crude oil volume was shifted to Natural Gas (Negative point).

Despite the above changes, MCX continues to have high number of speculators and lower number of Value Chain participants / hedgers –

Commodity VCPs/ Hedgers Prop Traders Others Total
ALUMINIUM 3% 27% 71% 100%
COPPER 1% 25% 74% 100%
COTTON 26% 24% 50% 100%
CPO 21% 36% 44% 100%
CRUDE OIL 0% 30% 70% 100%
GOLD 7% 31% 62% 100%
KAPAS 3% 28% 69% 100%
LEAD 3% 25% 72% 100%
MCXBULLDEX 1% 43% 56% 100%
MCXMETLDEX 1% 44% 55% 100%
MENTHAOIL 6% 62% 33% 100%
NATURALGAS 0% 30% 70% 100%
NICKEL 4% 36% 60% 100%
RUBBER 6% 11% 82% 100%
SILVER 5% 29% 66% 100%
ZINC 5% 26% 69% 100%
Grand 4% 30% 66% 100%
Data from Jan 21 to June 21. Source – MCX

As can be observed, only cotton and crude palm oil have a respectable composition of hedgers / VCPs, else its mostly prop traders.

This YTD data is based on a self declaration by participants, so there could be some hesitancy in reporting themselves as hedgers, but overall non speculative turnover still seems to be low.

Further, 42% of MCX turnover is generated by algo traders who are purely speculative.

Risks

For the longest, based on the regulatory behaviour, it seemed that MCX was not a very welcome presence in India’s finance ecosystem.

With open contracts leading to compulsory delivery, MCX can finally converge to the spot market and can actually help in better price discovery, efficient hedging and facilitate a national spot exchange in commodities through its tie ups and processes with various warehouses.

However, SEBI can move its fortunes to curb speculation and volatility in an instant, like it did by raising margins in crude oil contracts to 100% plus.

Increasing competition – In 2018, SEBI granted a universal operating licence to exchanges enabling them to deal with both equities and commodities. This led to lower entry barriers for NSE and BSE to start their commodity exchanges.

BSE has ramped up its volumes to an extent that it has 9% market share in commodities volume in India as of Mar 2021. This universal license also helped the broker to facilitate a common margin across all segments (cash, derivatives and commodities) of the customer, easing their trading on commodity exchanges of BSE and NSE.

MCX is burdened by these rules since it has no equity or currency products that it wants to introduce, and this diminishes its monopoly status.

However, as per MCX, BSE seems to be overstating its revenues – “So, we did take it up with SEBI, it is distorting the market and then people, the same way that you got misunderstood, people will think that there’s so much liquidity. No, absolutely not.

It is only a few players that are creating it, in good old days I was in BSE, how the market volumes are created I know, anyway, let’s not get into that.”

MCX is overhauling its entire technology stack to move away from high cost FTIL (which still supports the tech platform) to TCS, the development of which will start shortly.

Any untoward disruption on account of the same might lead to exchange losing its liquidity. Further as per BSE, MCX tech stack may not be able to facilitate options well – “due to the lower CTT a lot of people will move from the future to the options and we are rightly placed for providing this facility with the technology that is required well as we believe that other people who are now pretty much on the last leg of their technologies, which are themselves old may find it very difficult to match our technology and the user needs that they require in this kind of fast moving markets.”

Valuation

Like in 2016, when I first looked at it, I continue to be clueless about its future.

While I discarded this idea in 2016 with a mindset that the regulator does not want MCX to flourish, based on the changes in last 5 years, I am looking to revisit this assumption and now moving towards a thought process that the MCX wont be rendered obsolete in the near future (10 – 15 years).

The above is mostly an exercise in futility since:

  • A. in most years, different commodities fire at different speeds, so the above scenarios are outer boundaries.
  • B. I have not changed the multiples in different scenarios since what I want to focus on is the volatility in margins due to volatility in volumes with profit variance of 5x.

However, it helps me to focus on what are the various moving parts and I think I would be a buyer in the range of 2,000 – 3,000 crore market cap.

Happy Investing! Feel free to write below in case you have any views.

Further Reading:

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Umang Shah

Umang Shah

Through his writing, Umang shares his perspectives on how he thinks of investing, decision making, books and life in general.
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