Terms of Engagement
6 August 1999
Last Friday, after a last minute face-off with the Government, the terms of engagement in the arranged marriage between the Stock Exchange (SEHK) and Futures Exchange (HKFE) were announced. Neither board seemed particularly happy about the deal, but it will now be down to their members to vote on the scheme when it is put to them in September. If approved, the merger is expected to be consummated by 31-Jan-2000.
The terms of the merger are that each SEHK share will convert into 805,000 shares in Hong Kong Exchanges and Clearing Ltd (HKEC) while each HKFE share converts into 1,393,500 shares. There are 929 SEHK shares and only 230 HKFE shares, so the net result it that SEHK members get 70% and HKFE members get 30% of the new company.
Less Icing on the Cake
It had earlier been suggested that HKEC would offer to buy the trading rights of members at a fixed price for a period of time. In our article last week Icing on the Cake, we explained how this was likely to saddle the HKEC with debt and unsaleable trading rights. This is because there will be a surplus of trading rights as the industry consolidates and in the wake of the new Automated Matching System (AMS3). It appears that the Government has taken this point on board, and the merger terms do not include any such underwriting of trading rights.
HKEC has undertaken not to offer any new trading rights for 2 years after the merger, and then for the next 2 years, at not less than $3m per trading right on the SEHK or for $1.5m per trading right on the HKFE. That doesn't cost them much, because, as we explained in the earlier article, the price of trading rights will collapse anyway given the surplus of them. You should only need one trading right to operate a large internet brokerage through AMS3.
HKEC has also agreed to allow trading rights to be freely transferred (but once only) for 10 years after the merger. As a consequence, you can expect a rush of incorporation by individual members of the SEHK ahead of the merger. By transferring their SEHK share to a wholly-owned company, the company can then be sold ad infinitum without changing the legal ownership of the trading rights.
The Partial Cash Alternative
For those members who are nervous about the prospects of the HKEC, they have arranged a partial cash alternative (funded out of HKEC's combined resources) of up to HK$1,336m, at $3.88 per HKEC share (nice lucky number that). That covers about 32% of the shares to be issued. The cash is split 70:30 between the two exchanges.
We think there will be almost no take-up of this cash alternative, and we'll tell you why.
HKEC Combined Profits
For the first time, Webb-site.com has combined the profit and loss accounts of the three entities that will make up the HKEC, to show you roughly what their results are like. The entities are the SEHK (which owns The SEHK Options Clearing House), the HKFE (which owns the HKFE Clearing Corporation), and the Hong Kong Securities Clearing Company (HKSCC), which technically nobody owns. The HKFE has a December year-end and the SEHK and HKSCC have June year-ends. We haven't bothered to adjust for this as the necessary half-year results were not all available.
Here's the resulting combined profits for the latest financial year (for "surplus" read "profit" - all 3 companies are not run for-profit until after the merger, so the term "surplus" is used in the accounts):
Notice that the HKFE comes in at 29% of profits after tax, almost the same as the 30% share of HKEC that its members will get. The exceptional item for SEHK was the extra contribution it made to the Unified Exchange Compensation Fund in the wake of the collapse of C.A. Pacific Securities.
To show you that these results were not a flash in the pan, here's the previous year:
You can see now why the question of the valuation of HKSCC was so critical. HKSCC until now has existed as a non-profit entity and has regularly cut its charges as its surpluses have increased, benefiting its users. In future, it will hand some of those savings to its new shareholders in profits. What the shareholders gain, the users lose.
Now if we put these results side by side, and divide by the number of new HKEC shares, then hey presto - you can see that the earnings per share (EPS) for the latest published year was about $1 per share:
What this tells you is that the cash alternative values the HKEC shares at a historic p/e of just 3.9 times. If anyone accepts that offer, you have to wonder whether they ever had the expertise to handle your investments.
What Scheme of Control?
The Government has failed to adequately address the question of how the HKEC, which will have a legally-protected monopoly on share trading in Hong Kong, will set its prices. So far all they have said, in their recent policy paper, is that:
"the fees and charges of the two Exchanges are set out in their respective rules. The making of changes to these rules require the approval of the SFC."
That is simply not enough. For one thing, the SEHK rules do not actually set out most of their charges but instead Chapter 8 says:
"The Council [of the SEHK] shall have the power to impose fees and charges in relation to such matters or things and in such amount as the Council may from time to time think fit"
Such fees and charges are notified to members by way of a circular. We are told that in practice these circulars are subject to SFC approval, but there is no legal requirement for that. This has to change.
On top of this, it is not enough for a monopoly price regulator to just review requested price changes by the body it regulates. To be effective, it must have the power to require price reductions to be made. That is, it must be pro-active not re-active.
We hope that the Government will address these issues in the enabling legislation, but if they do not, then expect the profits of the HKEC to climb steeply in the future, and do not expect all the benefits of volume and technology savings to be passed on to you as customers.
So What's it Worth?
Under the current proposal, and as a monopoly in respect to the trading of shares in Hong Kong, it is not unreasonable to expect a P/E for the HKEC in the region of 12-15x, similar to other utilities. That puts a value on the shares of around $12-15, valuing the whole HKEC at around $12.8-16.0bn. It values each share in the existing exchanges as follows.
The value per SEHK share should make those small brokers who have opposed the merger stop and think - they get up to $12m worth of saleable shares in HKEC, and they get to keep their trading rights. In the past, their shares in SEHK were not permitted to pay any dividends and could only be sold if the business was sold. What a windfall!
One point worth noting is that the HKSCC, which contributed 35% of last year's combined profits, therefore contributes about 35% to the combined valuation, or about $4.5-5.6bn. That's the discounted value of future profits which will accrue to its new owners and which otherwise might have been passed to the public in reduced charges.
The only thing which could negatively impact on the HKEC's valuation is if a proper scheme of control were imposed, requiring the HKEC to hand back the bulk of its future profit growth in terms of continually reducing tariffs for all its services.
Still no word on what understanding (if any) the Government and the brokers have reached on minimum commissions. As we have explained in previous articles, the scrapping of this protectionist measure is the key to lowering transaction costs in Hong Kong and the development of a discount flat-fee brokerage market of the kind already found in the US (except that there is no monopoly and plenty of competition between electronic exchanges there).
Let's hope that the Government makes a clear commitment to proceed with scrapping minimum commissions as soon as the merger is completed. As we have shown in this article, no further incentives are needed for such a sweet deal to proceed.
© Webb-site.com, 1999