HKEX: How much policy "chicken blood" is currently priced in valuation?

At noon on October 23, Hong Kong time, HKEX.HK released its financial report for the third quarter of 2024.

Overall performance basically met expectations. Although the shift in China's macroeconomic policy at the end of the quarter sparked a wave of trading volume, the trading sentiment in the first two months of the third quarter was too poor. Therefore, in the entire quarter, the main business of trading clearing, listing, and other operations still remained under pressure as expected by the market.

However, during the phase of declining interest rates, the external portfolio income in investment returns still achieved better-than-expected performance, ultimately preventing a further decline in the overall operating profit margin due to flat trading income.

Since most of HKEX's revenue is related to market trading conditions, and market conditions are generally public information, with the company's official website disclosing information monthly, the actual performance is usually not significantly different from expectations. Valuation changes also fluctuate almost in a chain-like pattern with the current trading activity (such as the ADT index).

Generally speaking, most short-term bullish and bearish factors have already been fully priced in. From the perspective of influencing valuation, there are not many points to mention in the current performance. The Dolphin mainly uses financial reports to further understand the actual market situation and briefly explore some major changes within HKEX itself.

Specifically:

1. Flat Revenue, Highlight in Investment Returns

Here, "flat" refers to comparison with expectations. HKEX's revenue is strongly correlated with market trading volume, so market sentiment can have a significant impact.

Although trading volume surged at the end of the quarter, excluding the stimulated trading conditions, the third quarter itself was as expected (increased macro pressures inland, worsening marginal impact of financial reports in the second half of the year affecting trading sentiment, and some positive impact from the interest rate cut expectations starting in September). Overall, trading was still relatively subdued. This also led to a weakening of main business revenue other than investment returns in the third quarter.

With interest rates declining, external portfolio income performed better, offsetting the decline in margin investment returns. In the third quarter, in order to further reduce the impact of market volatility on HKEX's performance, the company reduced the proportion of equity holdings and increased government bonds and mortgage bonds.

2. Equity & Derivatives: IPO Financing Amount Soars, End-of-Quarter Trading Sentiment Rebounds

70% of HKEX's revenue comes from equity and derivatives market trading, so the pressure on trading income in the third quarter is related to the trading activity ADV.

Although the average daily trading volume ADV of equities and derivatives in the third quarter weakened slightly to 119 billion HKD, it still exceeded the key line of Dolphin's emotional freezing point of 100 billion. With the policy shift, the market opened up in a big way at the end of September, with trading volume in September directly increasing by 50%.

In addition to trading, the financing market in the third quarter was also not lackluster. On one hand, Midea Group listed on the Hong Kong stock market in mid-September, setting the highest financing amount on the Hong Kong stock market in 2021. On the other hand, Alibaba's entry into the market in early September also brought new activity to the market. As of the end of September, there are still 96 companies applying for IPOs in the pipeline3. Commodity Market: Continued Increase in Volume and Price

In the third quarter, the trading volume of the commodity market continued to remain strong, with the daily average trading volume of precious metal contracts increasing by 17% year-on-year. The simultaneous increase in volume and price, driven by the "price increase" (raising trading and settlement fees) at the beginning of 2024, has accelerated revenue growth.

4. Profit Margin: Expenditure Cycle Nearing its End

With the slowdown in revenue growth, the EBITDA profit margin of the Hong Kong Stock Exchange remained stable at 73% month-on-month in the third quarter, mainly due to the decrease in promotional expenses. Among other expenses, significant expenses such as employee costs and IT expenditures are still increasing, but the growth rates have been declining sequentially.

Generally speaking, the expenses of the Hong Kong Stock Exchange are relatively rigid. In the past year, expenses have increased due to "system upgrades" and "increased employee costs," but the growth rate further slowed down in the third quarter. It can be said to a certain extent that this round of "counter-cyclical investment" is gradually coming to an end. For the Hong Kong Stock Exchange, the subsequent performance elasticity is expected to significantly increase as market activity continues.

5. Overview of Financial Indicators

Dolphin's Viewpoint

As a securities trading market with relatively poor liquidity (annual turnover rate is only about 80%), the most core variable indicator in the performance of the Hong Kong Stock Exchange is the trading activity - the ADT average daily trading volume .

According to UBS calculations, historically, the valuation of the Hong Kong Stock Exchange is almost positively correlated with the change in this indicator, like a faucet switch. When sentiment is positive, valuation will rise accordingly. For example, when ADT is below 1 trillion, it corresponds to a P/E valuation center of 25x, and when ADT exceeds 2 trillion, the optimistic valuation can reach 40x.

Therefore, when domestic policies shifted at the end of September, and market sentiment improved, leading to a surge in ADT, the market value of the Hong Kong Stock Exchange also rose accordingly.

The performance in the third quarter itself reflects a relatively lagging situation in core variables, but in terms of overall operational efficiency, some signs of efficiency improvement can be seen through a stable profit margin level. Although the ADT in the third quarter declined compared to the second quarter, by relying on investment income and stable low-growth cost control, the profit margin level was maintained. While the Hong Kong Stock Exchange is currently in the late stage of this expenditure expansion cycle, it does not mean that expenses will converge in absolute terms, so performance elasticity still mainly relies on revenue growth**

As a result, both performance EPS and valuation expectations guided by sentiment are directly related to the increase in trading activity.

So, how much of the current valuation post-policy stimulus has priced in expectations?

1. Dolphin Jun calculated based on the current valuation and the historical P/E midpoint of 30x, with a current market value of HKD 39.5 billion, implying that the expectation for the ADT of shares + derivatives by 2025 can be maintained at a level of HKD 150-200 billion.

2. The ADT in the past months of August and September were HKD 95.5 billion and HKD 170 billion respectively, and during the "crazy trading week" after the policy was introduced, the ADT was HKD 300-400 billion.

Combining <1-2>, the current valuation does indeed price in some positive expectations for improved trading sentiment, but there is no "bubble" per se. If there are further stimulus policies introduced and implemented in the future, there is still hope to boost trading sentiment in the Hong Kong stock market, thereby raising valuations.

Below is a detailed analysis of the financial report

1. Introduction to Hong Kong Exchanges and Clearing Limited (HKEX)

2. Mediocre performance, with the only highlight being investment income

In the third quarter, HKEX achieved a total revenue and other income of HKD 5.372 billion, a year-on-year increase of 5.7%, mainly driven by investment income, followed by a slight recovery in stock and commodity trading from a year-on-year perspective.

Operating profit reached HKD 3.58 billion, a year-on-year increase of 7.1%, with a certain slowdown compared to the previous quarter. EBITDA was HKD 3.93 billion, an 8.4% year-on-year increase, both slightly lower than expected.

Generally speaking, HKEX's expenses are relatively rigid. In the past year, due to cost growth from system upgrades and increased employee expenses, the growth rate of expenses further slowed down in the third quarter. To some extent, it can be said that this round of "counter-cyclical investment" is gradually coming to an end, which means that for HKEX, the performance elasticity in the future will significantly increase under sustained market activity.

Of course, the end of the investment cycle does not mean no further investment, but rather that subsequent investments will generally follow income fluctuations within a certain range.

From the perspective of income structure:

In the third quarter, 51% of the Hong Kong Exchanges and Clearing Ltd.'s income and other income are directly related to trading (trading fees, clearing fees), 6.7% is listing fee income, which is indirectly related to the current market sentiment. From the perspective of listed companies, they are more inclined to go public when the sentiment is high, boosting market capitalization.

Investment income, accounting for 23%, performed better than expected in the third quarter. While margin income decreased due to a reduction in margin ratios, external portfolio income increased significantly due to lower interest rates and active stock and bond trading.

3. Trading Fees: Focus on the sustainability of trading sentiment

At the beginning of the third quarter, due to macroeconomic conditions and financial pressure, market sentiment was relatively weak. However, with the introduction of policy changes, trading sentiment surged at the end of September, driving a 13% year-on-year increase in trading fees.

The main markets where trading fees are charged are the equity market, derivatives market, and commodity market, and the following will elaborate on their performance:

(1) Stock Market: A frozen third quarter, with a frenzy at the end of the quarter

In terms of trading volume, the average daily turnover (ADT) of stocks in the third quarter increased by 23% year-on-year, reaching HKD 107.2 billion per day, higher than the frozen level of HKD 90 billion, but mainly supported by trading volume after policy stimulus, with trading in July and August being very sluggish.

The proportion of mainland funds' transactions in the third quarter as a whole showed a significant decrease compared to the previous quarter, but still saw a significant increase in southbound movements following the introduction of policies.

In reverse, the funds from Hong Kong flowing into the inland market have also significantly increased after policy stimulus, but the increase is not as high as the increase of funds flowing southward from the mainland (the turnover of northbound funds in September did not break the February record, but the turnover of southbound funds in September exceeded the previous high). This further confirms a fundamental investment logic that Dolphin Jun once mentioned last quarter:

During an interest rate reduction cycle, with the relative depreciation of the US dollar and increased liquidity in the capital markets, funds will flow preferentially to emerging markets, especially markets with low valuations and high-quality companies. Compared to the A-share market, the Hong Kong stock market has lower valuations and encompasses a large number of high-quality internet and technology companies, making it more favored by funds under this logic.

The total stock market trading fee income was HKD 770 million, a year-on-year increase of 17%, with the significant recovery of trading fees in the Hong Kong market offsetting a small part of the impact of the decline in A-share trading fees.

(2) Derivatives Market:

In the derivatives market, the bulk of the trading volume comes from the HKEX and HKEX Options, which were slightly active, but the total amount of warrants and bull/bear certificates remained unchanged, while the number of contracts increased significantly.

The number of contracts traded on the HKEX and HKEX Options increased by 4% and 19% respectively year-on-year. The daily average trading volume of warrants and bull/bear certificates in the third quarter increased by nearly 50% year-on-year.

How to view the surge in derivatives trading volume in the third quarter while fee income declined?

Most derivatives are charged based on the number of trading contracts, but in the third quarter, exchanges increased discounts and rebates on some contracts to attract trading volume, thereby reducing the average fee per contract, offsetting the increase in contract numbers' impact on fee income.

(3) Commodity Market: The dividend period of volume and price increase is coming to an end

In the third quarter, the commodity market continued to be driven by volume and price increases. LME trading and clearing fees increased by nearly 40% year-on-year, due to an increase in trading volume (metal contract numbers) by 25%, as well as the price increase effect starting from January 1, 2024.

Looking at specific varieties, nickel continued to maintain strong growth, but other metal sectors also saw varying degrees of volume increases. At the end of July 2024, LME announced the approval of Jeddah, Saudi Arabia as the delivery point for copper and zinc.

However, the income boost brought by the recent "suspension and resumption of nickel trading" + "price increase effect" will weaken next year. From monthly data, the growth rate of LME trading volume in August and September of the third quarter has rapidly converged.

4. Listing Fees: Record high financing amount for the year

In the third quarter, there were 15 new companies listed on the Hong Kong Stock Exchange (13 main board, 2 GEM), slightly lower year-on-year and month-on-month. However, due to the high financing amount of Midea Group, the total financing amount reached a new high for the year in a single quarter.

At the same time, 11 companies were delisted during the same period, maintaining stability in the short term. As a result, the total number of listed companies at the end of the quarter increased by 4 to 2621 (including main board and GEM).

IPO fees are mainly charged based on the number of companies, so "small number + high financing amount" does not necessarily mean that the Hong Kong Stock Exchange collects more fees. In addition, listing fees are not only paid by companies during IPO, but existing listed companies also have to pay a certain amount of listing fees to the Hong Kong Stock Exchange every year, which often accounts for a larger proportion (75-80%). Therefore, overall listing fees are still lower than the same period last year.

On the other hand, the number of new derivatives listings in the third quarter was small, which also dragged down the growth rate of overall listing fees. Ultimately, listing fees in the third quarter decreased by 2.7% year-on-year, reaching 360 million, still at one of the lowest levels in nearly two years.