NSE: Another strong year; but speed bumps ahead

23 May 2023 , 11:00 AM

Success of weekly Options (NSE is the largest derivative exchange globally) and increasing retail participation, drove volumes and earnings. However, analysts at IIFL Capital Services believe, FY24 could see moderation in earning growth given: 1) Tariff cuts 2) Increased regulatory contributions 3) Moderating volume growth (dwindling retail volumes + hike in STT). Separately, the company is divesting from non-core operations – this would lower cash burn (losses in new business+ acquisitions), making a strong case for higher payouts. In FY23, NSE declared dividend of Rs. 80/share (~3% yield) – equivalent to 55% of the profits versus 40% YoY. At Rs. 3,000/share (based on private market transactions), the stock trades inexpensively at 19x FY24 estimated EPS (Rs. 160), due to uncertainty around IPO and colocation case. Increasing payouts to enhance dividend yield attractiveness and offer downside protection.

Third consecutive year of strong performance

NSE’s reported PAT grew 42% YoY to Rs. 73.5 billion in FY23. Adjusting for one-offs (co-location penalty, SGF contribution and losses from discontinued operations), NSE’s profits were up 47% YoY to Rs. 77.3 billion. This is the third consecutive year of strong earnings growth. Profits registered 57% CAGR in last 3 years versus 24% CAGR in last 10 years (12% CAGR between FY13-20). Strong earnings growth is entirely driven by exponential rise seen in the Option volumes (success of weekly Options + increasing retail participation). Analysts at IIFL Capital Services note that in Equity cash and Futures segments – 3-year volume CAGR (14%/9%) is slower than 10-year CAGR (17%/16%); while in Options it is 2x (108% CAGR on 3-year basis versus 49% p.a. on 10-year basis). Resultantly, revenue share of Options has doubled to 80% (of total equity transaction revenues) in last 3 years.

Retail participation moderates in FY23; hike in STT weighs on Q1 derivative volumes

In FY23, Option premium volumes grew by 72% YoY to Rs. 477 billion ADTO; but volumes of Equity cash and Futures were down 20%/3% YoY to Rs. 534 billion/Rs. 1148 billion ADTO respectively. Regulations around client level margins (peak margins, restriction on broker funding, 50% cash margin, etc.) seem to be pushing volumes to the Option segment. But moderating retail participation also impacted volumes. Analysts at IIFL Capital Services note that retail net inflows in the secondary cash market were down 70% YoY to Rs. 492 billion (3-year low). Hence, share of retail in Equity cash turnover declined by 420 basis points YoY to 36.5% in FY23 (down 850 basis points from peak of 45% seen in FY21). Slowdown in new investor registrations and a consolidating market (in last 12-18 months) led to 25% decline in number of active retail investors in Cash market (down 33% from the peak; still higher than pre-pandemic level). In Equity derivatives – share of proprietary traders in total turnover has increased. While share of retail investor is steady in Options, it has fallen in Futures. From 1^st April 2023, the government has increased STT on Futures and Option trades by 25% – this impacted derivative volumes. In Q1FY24, QTD turnover is down 15% in equity Futures to Rs. 952 billion ADTO; and 6% in equity Options to Rs. 558 billion ADTO (premium turnover) versus Q4FY23 average. However, Cash volumes are up 10% to Rs. 541 billion ADTO.

Tariff cuts, additional regulatory contributions to weigh on earnings growth

From 1^st April 2023, NSE has reversed the tariff increase it had taken in January 2021 – this would result in 6% reduction in Exchange fees across Equity products. The company shared that a 2% additional charge would be recovered from members for contribution towards investor protection fund (IPF). Although this would moderate the revenue decline, this would not cushion earnings impact as the money gets transferred to IPF. Furthermore, the company has decided to transfer 2% of transaction revenues to the SGF fund (Rs. 2.3 billion transferred in Q4FY23 for whole of FY23) – this would add to the cost pressure. NSE targets to increase SGF fund from Rs. 53 billion now to Rs. 100 billion over next few years. It has decided to appropriate Rs. 66 billion or 1/3^rd of the net worth towards risk capital management, including transfer to SGF fund. While no additional details are shared as yet, this could effectively lower the free cash (estimated at Rs. 150-160 billion) available for distribution.

No clarity on IPO timelines; FY24 earnings growth to see moderation

NSE management shared that they are awaiting regulatory approvals for IPO and cannot share any timelines. On co-location case, SEBI has challenged SAT order in the Supreme Court (SC). The SC directed SEBI to refund Rs. 3 billion (of Rs. 10 billion), provided NSE would repay SEBI if its petition is allowed (NSE received money on 21 April 2023). The matter is now listed for hearing in September 2023. Coming to business, analysts at IIFL Capital Services estimate FY24 profit growth to be subdued given tariff cuts, higher regulatory costs and moderating volumes (particularly in Equity Futures). From 3^rd July 2023, SGX-IFSC connect will be fully functional and all orders from SGX would be routed to NSE IFSC. However, analysts at IIFL Capital Services do not expect any material revenue contribution; given small scale of operations and loss of licensing revenues. Separately, SEBI has directed NSE to divest all its non-core investments (process for divestment of its Technology and Education business has started – BV of Rs. 3.5 billion) and to focus on core Exchange business (now more focus is likely in Commodities – new CME-linked Energy contracts are introduced, IFSC, etc.), this would lower cash requirements (NSE was acquiring companies to grow in Tech and data analytics business) paving way for higher pay-outs once the regulatory capital requirements are met. In FY23, NSE announced final dividend of Rs. 80/share – 55% payout versus 40% a year ago.