Here is what we are unpacking today:
- How do stock exchanges make money?
- BSE’s current business model, its investments, and subsidiaries
- The new management in place and foray into Index derivatives
- The progress of the turnaround
- How BSE is competing with NSE?
- The stock’s 300% rise in 6 months: what’s next?
- Risks, Growth triggers, etc
Elevator pitch: A business segment (Index derivatives) that didn’t exist 6 months back is expected to contribute around 30% of overall revenue in the next one year and is projected to grow up to 45% in two to three years.
What role does a stock exchange play?
You own shares of RIL and would like to sell them. Either because you need to fund a home purchase with the proceeds or you believe the company is headed for difficult times and you’d like to buy another company in its place.
If stock exchanges did not exist, you’d have to look for a willing buyer. Someone who believes that RIL is currently undervalued and believes the opposite of what you do. You would negotiate a price and hand over the shares after confirming you’ve received payment.
You would repeat the process every time you bought or sold. Stock exchanges take the uncertainty out of the transaction. As centralised marketplaces, they list buyers and sellers. Prospective buyers and sellers can both see what price stocks have been exchanged at. The exchanges also ensure the seller actually has the shares they are looking to sell and the buyer has the money available to pay by applying regulations that the brokers are required to adhere to.
If there is a buyer for the stock you’re selling, the exchange helps you connect and complete the trade.
*click on the image to enlarge
How stock exchanges make money
- Transaction-level trading and clearing fees for each transaction.
- Listing newly public companies and for ongoing maintenance fees.
- Selling real-time market data and information to investors, data vendors, and media companies (like the ticker tape you see on CNBC TV18 or ET Now).
Together, these segments create the financial backbone of stock exchanges, with some areas being more affected by market fluctuations than others.
*click on the image to enlarge
BSE Limited (formerly the Bombay Stock Exchange) was formed on July 9th, 1875. It was the first stock exchange in Asia. As of Dec 2023, BSE is the largest exchange by number of listed companies (5000+ companies). It is India’s first & world’s 9th largest exchange by market capitalization of $4.1 Trillion as of Dec 2023.
Trading and clearing forms 49.5% of overall revenue. Listing Business contributes 27.5% with fees from new securities and maintenance; Data Services at 14.8% from selling market data; and Distribution accounts for 8.2% through mutual funds & bonds platform fees.
The Equity Cash segment at BSE shows a decent trend with an average daily turnover of 4996 Cr and a growth of 13.3% over the last five years. NSE dominates with a 93% share, but BSE aims to increase its 7% share to double digits soon. In H1FY24, BSE earned 99.7 Cr from this segment, making up 15.7% of its total revenue.
In addition, BSE has recently introduced a new segment in Equity and index derivatives, contributing around 4% to its revenue, marking a significant development in its offerings.
These are their core standalone business segments. However, they have subsidiaries & strategic investments in companies that are part of the same trading & investing ecosystem, like Clearing house, Depository services, Commodity exchange, Mutual Fund distribution, Bond platform, etc., to name a few.
BSE derives significant value from its Investments, Subsidiaries & Joint ventures.
- BSE owns StAR MF platform
- Holds a 15% stake in CDSL
- 90% stake in India INX exchange
- 100% stake in Indian Clearing Corporation Limited (ICCL)
- 40% stake in BSE Ebix Insurance broking
StAR MF Platform – A Pivotal Asset
In 2009, BSE introduced the BSE StAR, a web-based system for mutual fund order placement and settlement. BSE StAR allows mutual fund intermediaries to handle applications and redemptions for open-ended schemes. Over time, the platform has achieved significant growth, now encompassing:
- 40 registered AMCs.
- 10,950 mutual fund schemes.
- 75,695 distributors across 739 cities and towns.
With an impressive 89% market share, the StAR MF platform is a major revenue driver for BSE. Mutual Fund AMCs contribute to this success by paying a service charge of about 5/- per transaction processed on the StAR MF platform. This platform has become a significant income source for BSE, currently generating an annual revenue of approximately 80 Cr and maintaining a net profit margin between 35-40%.
CDSL Stake: Another Winning Bet for BSE
For more than a decade and a half, NSDL reigned as the leader in the depository space. However, the landscape shifted in 2020-21 when CDSL surpassed NSDL, becoming the largest depository. CDSL now holds 53% market share in terms of revenue. Its revenue streams include annual maintenance and fees per transaction.
*Source: NSDL DRHP
BSE has gradually been decreasing its stake in CDSL. In 2017, BSE divested a 26% stake through an IPO and recently reduced it further by 10%, bringing its current holding to 15%. Since going public in 2017, CDSL has shown consistent performance as a steady compounder. The company’s current market capitalization stands at 20,000 Cr, attributing a valuation of 3000 Cr to BSE’s stake.
India International Exchange: A Startup
India INX, a 61% subsidiary of BSE Limited, is India’s first international exchange, located at GIFT City. It commenced operations on January 16, 2017.
An International Exchange, like India INX, provides direct access to foreign entities in India, offering a range of asset derivatives, including Equity & Index F&O, Commodities, Currency, Euro bonds, and Masala bonds. This platform stands out from domestic markets by permitting FPIs to trade in commodities and operate for 22 hours each day. All trades are ensured and cleared through ICCL, a subsidiary of BSE. Major advantages include the absence of currency risk, capital gain tax, dividend distribution tax, and a 10-year income tax holiday.
Things are moving slowly for the India INX exchange. The average daily number of contracts has grown at a CAGR of 31% to 6.9 lakh contracts. However, despite increasing trading volumes and liquidity, the exchange has yet to turn profitable. In FY23, India INX generated a revenue of 6 Cr and a loss of 29.6 Cr. It is currently in its investment stage. Understanding this, BSE is infusing 33.8 Cr into India INX exchange as additional capital. It will take some time before India INX starts to contribute to BSE’s consolidated profits.
*Source: India INX Annual Report 2023
Indian Clearing Corporation (ICCL)
Incorporated in 2007, ICCL is a wholly owned subsidiary of BSE Limited. The market share of clearing corporations largely mirrors the market share of parents BSE (ICCL) & NSE (NSCCL).
In 2019, SEBI introduced the interoperability of clearing corporations. It allows one clearing corporation to execute and settle trades of any other exchange. Market participants can choose any clearing house to settle their trades, irrespective of the exchange where the trades are executed. Unlike INX exchange, ICCL is profitable with revenue of 216 Cr and profits of 33.1 Cr as of FY23. As of now, BSE doesn’t have any plans to divest ICCL & owns 100% of the company.
BSE Ebix & HPX Power exchange
BSE Ebix, a joint venture formed by BSE Limited (40%) and Ebix Fincorp Exchange Pte Ltd (60%), began operations in 2020, offering Auto and Health insurance services. As of September 2023, its impact remains limited, with a total premium collection of 29 Cr. BSE’s investment in this venture amounts to 14 Cr to date. An important aspect to monitor is EBIX Global’s recent bankruptcy filing and the planned IPO of its Indian subsidiary. This raises questions about EBIX’s future stake in the JV. Nevertheless, given the venture’s relatively small scale, its influence on BSE’s overall revenue and investment profile is minimal.
BSE also owns 23% in the new power exchange Hindustan Power Exchange (HPX) along with PTC Limited (23%) and ICICI Bank (9%). This again is still in its nascent stage and is loss-making.
All these aspects are fine, but they are not extraordinary. If things had just stopped there, we probably wouldn’t be talking about BSE now.
A new chapter begins: Mr. Ramamurthy steps in
BSE Limited was just coasting along, trying to kickstart growth through various channels like BSE StAR MF, Bonds, Commodities, Insurance broking, and more. They were hustling hard, moving in all directions, but still seemed stuck in the same spot without noticeable traction. They knew that they had to crack the main piece of the puzzle – derivatives, without which, the growth might not be long-lasting and sustainable.
Mr. Sundararaman Ramamurthy, an ex-NSE veteran and the architect of Bank Nifty derivatives, took over as the new MD & CEO of BSE in January 2023. His primary task was to breathe new life into the derivatives segment at BSE, a challenge considering the exchange’s unsuccessful attempt to revive Index derivatives back in 2017. This time, with a narrow margin for error, his expertise was crucial.
He consulted with several brokers, and they suggested:
- The need for introducing a Sensex 30 derivative product
- Not to plan it on Thursdays (to circumvent clashing with Nifty expiry)
- To keep the lot size at the regulatory minimum (rather than opting for a larger amount such as 10 Lakhs, etc.)
In May, BSE launched derivatives with a lower lot size than NSE options, featuring unique Friday and Monday expiries, and at a steep discount (flat ₹500 per Cr) compared to NSE’s premium pricing. This strategic move marked a significant shift, and things started moving at a promising pace for BSE. The average daily premium turnover (ADTO) has risen from zero in May 2023 to ₹2250 Cr currently, capturing a market share (premium) of 4%.
Buoyed by this positive response, BSE, from November 1st, increased tariffs on equity options from ₹500 per Cr to ₹2600 per Cr (blended pricing), a bold 5.2x jump. This step proved to be a major boost in revenues.
In Nov 2023, the average daily premium turnover was ₹1805 Cr and it is growing at a 30+% month-on-month rate (on a lower base, though). At the old pricing, in October 2023, BSE had a monthly revenue of around ₹4 Cr. From November 1st, with the new pricing, they will be making around ₹18-20 Cr revenue per month.
A back-of-the-envelope calculation:
- For our assumptions, let’s consider a month-on-month growth rate of around 5% for the next year, bringing it closer to around ₹3400 Cr ADTO.
- With the increased pricing, we are looking at a cumulative additional revenue of around ₹300 to 350 Cr in the next 12 months, an increase of about 30% from overall TTM revenue (₹1120 Cr).
- This is decent growth in ADTO. However, if the current run rate continues, the ADTO is expected to double in one year (to ~₹7000 Cr).
How is BSE positioned compared to NSE?
- Instead of directly competing with the giant NSE India, BSE has strategically created products with different expiry days that complement NSE’s highest-traded products (offering Sensex options for Nifty traders and Bankex options for Bank Nifty traders).
- NSE has generated a TTM revenue of 13,749 Cr and a PAT of 7,500 Cr. In the unlisted market, NSE is currently trading at a market cap of approximately 1.5 Lac Cr, which implies a PE ratio of 20 times on a trailing basis. These valuations seem somewhat depressed, likely due to illiquidity and ambiguity regarding the listing. Once NSE lists, given its market leadership, robust balance sheet, and the free cash flow nature of the business, it could command a higher premium than it currently does in the unlisted market. Meanwhile, BSE is trading at a market cap of 32,000 Cr.
- Even at ₹2600 per Cr pricing, BSE still offers a discount of around 16% on a blended basis compared to NSE’s pricing.
- In all likelihood, BSE will maintain competitive pricing, slightly lower than NSE’s, to gain market share and gradually shift volumes to BSE.
- BSE market share in total premium turnover is currently at 4%. This is expected to reach 12-15% in the next three years.
Stock is up 300% in 6 months: What next?
Yes, the stock has seen a considerable run-up in the last two quarters. But this isn’t just speculative; it’s backed by a real shift in the company’s fundamentals and business model. The current PE (TTM) of 90 times might not be the best yardstick for valuation here, given that the major changes and turnaround only started about 2-3 months back, specifically from November 1st, 2023.
If this growth trend holds, we’re looking at BSE potentially clocking in revenues of 1800-2000 Cr and a PAT in the range of 600-800 Cr by FY26E. This puts the forward PE at about 40 times over two years. Sure, it seems fully valued by standard measures, but if F&O volumes keep growing for the next five years, there’s still a long runway ahead for the company.
Growth Coming Back to Quality is a theme that we look out for. We pay close attention when a high-quality company shows signs of growth resumption. This growth can stem from various factors, such as:
- Management change (Jubilant Foodworks in 2017, Bata in 2019)
- New acquisition (Tata Consumer in 2020)
- Corporate rejig (Magma Fincorp takeover by Poonawalla Group in 2021)
BSE is a recent example of this framework. The growth has come back after more than a decade. This type of growth is sustainable because the underlying company usually already possesses a healthy balance sheet and cash flows. What they need is growth. Once these companies achieve the required kicker, the market often re-rates them, and their premium valuation continues as long as the growth persists.
Inside scoop: Management’s path ahead
- The management agrees that NSE will remain a top player in the market for a long time. However, India needs to reduce its reliance on just one major player.
- The BSE aims to grow its market share in Cash Equity from 7% to 10%.
- Their immediate focus isn’t on increasing profits but on preventing any losses. What does this mean? Previously, the BSE charged a fixed fee of 500 rupees per crore of Sensex option premiums. But they had to pay 1500 rupees per crore to the National Clearing Corporation (NCL). This was their cost for the first six months, now increased to 2600 rupees for early expiry weeks. The fee for later weeks and Bankex options remains at 500 rupees. The management believes this increased fee covers the extra costs for these options. As Bankex gets more business, they plan to raise its fees too, like the Sensex options.
- In future quarters, the BSE will focus more on making profits as Sensex and Bankex grow.
- ICCL faces a similar risk of market concentration. NCL holds 96% of the market, while ICCL has only 4%. If regulations change, like separating clearing charges, BSE could set more competitive prices for both the exchange and clearing house.
A recent interview discussing the management’s outlook on future growth opportunities:
Capitalmind Checklist
Can BSE stand the competitive intensity from NSE?
- The exchange business is a duopoly and will remain so for the foreseeable future. BSE is a market leader in the Bond Segment. It is giving good competition to NSE in Currency and commodity derivatives. However, there hasn’t been much success in Equity derivatives, which is currently changing. BSE is strategically focusing on niche segments to capture market share from NSE.
Is the company financially healthy?
- Yes. BSE generates ~250 to 300 Cr of free cash flow every year. It is a low capex and high margin business. 40% of revenues are recurring and not linked to the market. BSE is a cash-rich company and holds around 1900 Cr on their balance sheet.
Is the management sketchy?
- No. BSE is a professionally managed company. LIC is the largest shareholder with a 5.6% stake, followed by Zerodha with a 3.7% stake. The management is focused on its line of business and has not ventured into unrelated areas. BSE was viewed as a problem earlier, when the Exchange president Anand Rathi once got rapped by SEBI for having asked the BSE surveillance department for position status of a few institutions, which could have benefited his company. This has since changed with management that is not allowed to be from the brokers themselves. Management compensation is below the ceiling of 10%.
Is the stock cheap?
- Surely not. The stock is currently trading at 88 times PE (TTM) & EV/EBITDA of 47 times. At this valuation, there is no scope for error. However, we believe the company can deliver in the next 3-5 years.
What are the potential triggers?
- Sensex & Bankex derivatives
- Volumes going up in Debt markets. BSE is the market leader in the Bond market with a market share of 59%.
- Smart order routing enables the brokers to systematically choose the execution destination based on factors like price, costs & speed. Any small % shift from NSE with 94% market share can be a huge booster to BSE with 6% market share in the Equity cash segment.
- Strong growth in the StAR MF platform & monetization of it.
- Growth in turnover in India International Exchange.
- Commodities Derivatives segment where BSE has a market share of 41% and is growing.
What are the Risks?
- This isn’t BSE’s first shot at equity derivatives. They tried back in 2017 but didn’t make it. It’s a mammoth task to break into NSE’s stronghold and carve out a piece of the market.
- Right now, we’re in a bull market, and that’s driving a massive increase in index derivative volumes month after month. But once the market hype calms down, we might see a decrease in these volumes.
- The biggest risk, though, is pulling it off. Everything needs to line up just right for BSE to grab a significant market share in Index and equity derivatives – like the right market conditions, regulator’s support, management’s efforts, and the whole ecosystem.
What would make us change our opinion on this stock?
- As of now, the company is taking the right steps in the right direction. As long as they are on the right track, holding the stock over a long period shouldn’t be a problem.
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Disclosure: Please note that we hold BSE Limited in our model portfolios. This article is intended solely for informational purposes and should not be construed as an investment recommendation.
