Hong Kong-LME Deal Spurs Biggest Exchange Drop: Real M&A
Hong Kong Exchanges & Clearing Ltd.’s pursuit of the London Metal Exchange is transforming the Asian bourse into the industry’s worst performer.
Hong Kong Exchanges’ $2.2 billion bid for the LME this month valued the world’s largest trading venue for industrial metals at 181 times earnings, making it the most expensive bourse acquisition exceeding $1 billion on record, according to data compiled by Bloomberg. With the Asian company’s stock tumbling since the first report of its interest in the LME, it has now retreated 33 percent in the past year, the biggest decline among the world’s 20 largest exchanges, the data show.
While the merger will give Hong Kong Exchanges control of about 80 percent of global trade in industrial-metal futures as it grapples with falling profits and a slump in initial public offerings, the New York Stock Exchange (NYX)’s head said the price would have been too rich for the biggest U.S. bourse operator. An increase in trading by Chinese companies on the LME is vital to justify the deal, making the takeover’s success dependent on China’s regulators, who have so far resisted granting the LME access to the mainland to protect its rival in Shanghai, according to Core Pacific-Yamaichi International (H.K.) Ltd.
“In the short-term, this acquisition will be a huge burden,” Michiya Tomita, a Hong Kong-based fund manager at Mitsubishi UFJ Asset Management Co., which oversees $65 billion, said in a phone interview. “The valuation they’re buying LME for is expensive. This investment could pay off eventually if they are able to boost China’s trading volumes on LME, but that’s not easy to achieve given current regulatory restrictions.”
Hong Kong Exchanges, formed a decade ago through the combination of the city’s equity and derivatives markets, has focused on stocks, options and futures on equity indexes and interest rates. The 135-year-old LME, which reported record volume of $15.4 trillion last year, sets global benchmark prices for metals including copper, aluminum and nickel, of which China consumes more than any other nation.
Trading volume on the LME grew about 58 percent between 2007 and 2011, according to data from the exchange. UBS AG analyst Stephen Andrews forecasts trading will increase to 261 million lots by 2015, from about 147 million lots in 2011, according to a June 18 note.
“This deal is about growth over not just one or two years, but over the longer term,” James Fok, chief of staff to Hong Kong Exchanges’ (388) Chief Executive Officer Charles Li, said in a phone interview. “As a standalone business, LME has quite an attractive growth rate. On top of that, what we’re able to help plug it into are areas of growth that it’s not capturing today - - in particular China -- that are able to boost that growth quite substantially.”
“From our point of view we think the valuation stacks up very well,” he said.
After rising as much as 3.3 percent earlier today, Hong Kong Exchanges fell 10 cents to HK$108.60 apiece.
Miriam Heywood, a spokeswoman for LME, declined to comment on the price Hong Kong Exchanges offered for the firm.
Hong Kong Exchanges said on June 15 it had agreed to pay 1.39 billion pounds ($2.2 billion) for LME, or 181 times the London-based company’s 2011 earnings of 7.68 million pounds, according to data compiled by Bloomberg.
The LME purchase price was almost double the prior record for an exchange deal exceeding $1 billion, the data show. The merger of Sao Paulo-based Bolsa de Mercadorias & Futuros-BM&F SA and Bovespa Holding SA to create Latin America’s biggest stock and futures exchange valued Bovespa at 107 times profit when it was announced in March 2008, data compiled by Bloomberg show.
The member-owned LME’s previous profits are “of limited relevance” because the bourse kept fees low for the benefit of its shareholders, Hong Kong Exchanges said in a June 15 statement. Had a fee increase scheduled for next month taken place before 2011, profits would have tripled to 23.8 million pounds last year, it said.
With that level of earnings, the takeover would value LME at 58 times profit. That would still leave Hong Kong’s bid as the third-most expensive for a bourse on record, behind the BM&F-Bovespa merger and the Chicago Mercantile Exchange’s October 2006 offer for the Chicago Board of Trade, according to data compiled by Bloomberg. The Bloomberg World Exchanges Index (BNWEXCH) of 25 bourses traded at almost twice its current price-earnings multiple when the deal to create the current Chicago-based CME Group Inc. (CME) was announced, the data show.
“The earnings don’t justify the price,” Thomas Monaco, an analyst at Mizuho Securities Asia Ltd. in Hong Kong, said in a telephone interview. “I don’t see it being positive for earnings, which is essentially what the stock trades off of. I think they’ve bitten off much more than they can chew.”
Taking into account the agreement by Hong Kong Exchanges not to raise fees on the LME until 2015, Monaco estimated in a June 18 note that the bourse will have to double the LME’s profits in order to avoid cutting its dividend or selling new shares to finance the deal.
“This was a value-destructive deal and the company should not be doing something like this,” Monaco said.
NYSE Euronext’s CEO Duncan Niederauer said on June 8 that the LME had become too expensive for the operator of the New York Stock Exchange. NYSE Euronext had said in May it was removed from the list of potential buyers.
“We weren’t going to chase it,” Niederauer said at the Sandler O’Neill Global Exchange and Brokerage Conference in New York. “The price it’ll likely trade at, frankly, it was too rich in terms of what we were able to afford to pay.”
Hong Kong Exchanges’ bid has left New York-based JPMorgan Chase & Co. poised to more than double the value of its investment in LME shares bought seven months ago from the U.K. unit of bankrupt MF Global Holdings Ltd. The New York-based bank is the biggest investor in the LME with 1.4 million shares valued at 150.6 million pounds after Hong Kong’s offer of 107.60 pounds per ordinary share.
New York-based Goldman Sachs Group Inc. (GS)’s stake of 1.23 million shares in LME is valued at 132.3 million pounds. U.K. metals trading companies Metdist Ltd. and Metdist Trading Ltd. have a combined 1.21 million LME shares, valued at about 130 million pounds after the offer.
Hong Kong Exchanges, which had $5.7 billion in cash and short-term investments at the end of March, is borrowing 1.1 billion pounds for the purchase and plans to sell stock or bonds to refinance the loans. The company is likely to issue 10 percent of its share capital to raise funds, according to Ivan Li, an analyst at Kim Eng Securities in Hong Kong.
“Its share price may be under pressure again at that time,” Li wrote in a June 20 note. Li cut his forecast for Hong Kong Exchange’s 2012 earnings by about 10 percent and the price estimate on the stock to HK$90 a share, or 17 percent below last week’s close.
With the announcement of the LME acquisition sending Hong Kong Exchanges to the largest drop in the city’s benchmark Hang Seng Index on June 18, the bourse has now tumbled 33 percent in the past year. That’s a bigger slump than any global exchange with a market value of more than $500 million, data compiled by Bloomberg show. Most of the decline has come since the South China Morning Post newspaper first reported the bourse’s interest in LME in February.
The deal price means that Hong Kong Exchanges will have to boost LME’s revenue to at least 400 million pounds, from 61 million pounds in 2011, if it is to meet its own goal of a 10 percent to 15 percent return on investment for the acquisition in five years, UBS’s Andrews said. The purchase is unlikely to make more than a “mid-single digit” return on investment in the next three to five years, according to a June 18 note from Andrews, who factored in the cost of financing and U.K. taxes.
“There are clearly strategic benefits for Hong Kong from owning this asset but for HKEx’s shareholders acquisitions need to generate a good return on cash invested to add value,” Andrews wrote. “LME may well come up short of expectations in this regard.”
Hong Kong plans to increase the London exchange’s revenue in part by tapping the large potential base of customers in China, which accounts for about 40 percent of consumption of commodities globally and only as much as 25 percent of trading on the LME, the company said when announcing the deal.
To increase trading by Chinese firms, the LME will need permission to register warehouses in mainland China, according to Timothy Li, a Hong Kong-based senior analyst for Core-Pacific Yamaichi. That may not be forthcoming with Chinese regulators interested in protecting the Shanghai Futures Exchange from competition, he said.
The China Securities Regulatory Commission, which is responsible both for regulating trading and developing China’s domestic markets, has prohibited foreign bourses from setting up warehouses for delivery of commodities. The ban is in place until the government issues rules on the opening of futures markets, the CSRC said in a July 2008 statement. The CSRC hasn’t said when that will happen and didn’t respond to a request for comment outside normal business hours.
“Whether you are a producer, user or trader, warehouse delivery is an important part of commodity trading,” Zhang Yifan, a commodity strategist at China Galaxy Securities Co., said by phone from Shanghai. “Obstacles for overseas exchanges to set up delivery warehouses in China gives domestic players less incentive to trade on the foreign exchanges.”
The CSRC also controls Chinese companies’ ability to trade commodity futures in overseas exchanges, including the LME.
“They need to boost LME trades from China,” Core Pacific- Yamaichi’s Li said in a telephone interview. “China’s interest in protecting the Shanghai Futures Exchange from overseas competition may make this difficult.”
Before Hong Kong Exchanges agreed to the deal for LME, analysts were projecting it would report earnings of about HK$5 billion ($640 million) in 2012, the fifth year of falling or unchanged profits since 2007. The average of analyst forecasts dropped to HK$4.9 billion in the past week, data compiled by Bloomberg show.
Hong Kong has accounted for about 5 percent of the global amount raised through new listings this year, compared with 13 percent in 2011 and 18 percent in 2010, according to data compiled by Bloomberg.
The acquisition of LME will have a “significant impact” on Hong Kong’s ability to boost its profits as it increases trading fees and expands its offering of products denominated in renminbi in the world’s fastest growing major economy, according to Simmy Grewal, London-based senior analyst at Aite Group LLC.
“The potential is very large and that is what Hong Kong is paying for,” Grewal said in a phone interview. “They’ve been very smart about diversifying to now look at commodities. They didn’t want more exposure to equities, so they realized they needed to diversify and get to a completely different space that also complements the exposure to China because that is something that no other exchange in the world has.”
With the takeover unlikely to boost Hong Kong’s earnings in the short-term, investors may still grow more impatient given the uncertainty about the merged entity’s ability to get the necessary access to China, according to Mizuho’s Monaco.
“This is a very, very long-term thing,” he said. “We don’t know if they’ll be able to get the warehouses in China. We have no idea.”