Australian Stock Exchange (ASX: ASX) reported first-half underlying net profit after tax up 4%, as 11% operating revenue growth was damped by a 20% increase in total expenses. ASX declared a dividend of $0.10 for the period, down 9% on the prior year.

Why it matters: The results were as preliminarily announced in late January. ASX is seeing abnormal cost growth, and we expect this to continue in the near term. It also announced that Managing Director and CEO Helen Lofthouse will step down in May. The exchange has started looking for a new CEO.

  • We don’t expect the new CEO will diverge much from Lofthouse’s strategy, which includes replacing the aging CHESS system with the help of TCS and investing heavily in other systems, primarily to placate the regulator, in our view.
  • The stepping down of Lofthouse follows the scathing interim report by the Australian Securities and Investments Commission in December, which asserted that ASX had given undue prioritization to shareholder returns at the expense of technology investment.

The bottom line: We maintain our $70 fair value estimate for wide-moat ASX. The shares screen as materially undervalued, as the exchange has faced regulatory setbacks for the past year and the full ASIC report is still to be released.

  • We believe current spending levels are elevated and will normalize when regulatory interest eventually dies down. Cost growth has been primarily driven by regulatory costs. Excluding regulatory and inquiry expenses, costs only increased 8%, which was below the increase in revenue.
  • We view the value of the exchange as derived from strong economic moats that can withstand leadership volatility.

Coming up: Although we believe Lofthouse made the right decisions in dealing with the challenges she inherited from her predecessor, we believe a new CEO will provide an opportunity for the exchange to build new relations with the regulator.

ASX’s new leadership allows for reset

We expect Australian Securities Exchange’s near- and medium-term strategic focus to be on protecting its economic moat in cash equity clearing and settlement. ASX has long been protected from competition through various exclusive licences to clearing and settlement, which we consider a source of its economic moat, based on intangibles. However, over the past decade, ASX has faced increasing calls from the federal government, regulators, and industry bodies for more competition.

In response to these calls, ASX attempted to deliver a world-leading new clearing system based on blockchain. But after several years of delays and cost overruns, this project has been binned, which has renewed discussion on opening up the clearing and settlement market to more competition. We expect ASX will therefore focus on trying to demonstrate to the federal government, regulators, and industry bodies that it is capable of maintaining smooth operations of Australia’s financial infrastructure, including by increasing spending on its various systems.

Regardless of the potential regulatory outcome, cash equity clearing and settlement make up only around 15% of ASX’s revenue. Moreover, we believe that even if cash equity clearing and settlement were opened up to competition, ASX’s business would remain well protected due to network effects inherent in its clearing business. We therefore do not expect significant changes to ASX’s cash equity clearing and settlement market share or margins in the foreseeable future.

Bulls say

  • ASX is a vertically integrated exchange with a wide moat based on network effects and intangibles.
  • ASX benefits from exposure to Australia’s outsize natural resources sector, and the energy transition will continue to fuel demand for ASX’s listing services.
  • Volatility will increase demand for ASX’s trading and clearing services, especially for companies in the highly volatile materials and energy sectors, which make up around half of total listings.

Bears say

  • ASX has failed to adequately secure its economic moat based on regulation and now risks increased competition and costs.
  • ASX has not yet presented a credible plan to replace its ageing clearing system.
  • Uncertainty in financial markets may negatively affect ASX’s listings business, which is disproportionately large compared with peer exchanges.

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company’s future cash flows, resulting from our analysts’ independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.