A price-to-earnings ratio of 156 can look like a good deal
Last Friday Monitor cast its eye over Hong Kong Exchanges and Clearing's proposed takeover of the London Metal Exchange.
The LME would be 'a challenging acquisition', Monitor argued, and HKEx could find 'extracting value from its takeover is a tougher proposition than it expects.'
Even so, the column concluded, handsome growth prospects mean that 'from the point of view of a cash-rich HKEx and its Hong Kong government shareholder, the LME is a prize well worth bidding for.'
One reader disagreed - vehemently.
'You managed to write a positive piece without mentioning the horrific price to earnings ratio that HKEx is proposing to pay,' he wrote.
Our disgruntled reader pointed out that if you divide the GBP1.2 billion HKEx is rumoured to have bid for the LME by the London exchange's reported 2011 profit of GBP7.7 million [HK$93.8 million], you get a price-to-earnings ratio of 156.
'It's enough to make Facebook look like a discounted value stock,' he complained.
Well yes, a price to earnings ratio of 156 does sound eye-wateringly high. But for the LME it's a misleading valuation.
For one thing, both numbers are uncertain. The LME hasn't yet published any financial statements for 2011, and the ?7.7 million profit figure comes from a single unconfirmed report in a British newspaper.
Similarly little is known for sure about either the size or the structure of HKEx's bid for the LME. A figure of ?1.2 billion has been mentioned in unsourced reports, but so have more modest amounts.
Even so, if you take the LME's 2010 net profit of ?9.5 million and the often quoted price tag of ?1 billion, you still get a deal priced at 105 times earnings, which is still breathtakingly high.
However, there are a few other factors to consider.
First, the LME has never been run to maximise profits for its shareholders. As a marketplace owned by its members, it has traditionally been managed more as a service to its brokers than as a money-making concern.
As a result, the LME's trading fees are just a fraction of those charged by other futures exchanges. For example, a simple round trip trade for one lot of copper on the LME costs members less than a tenth the amount it would cost them to trade the equivalent amount of the metal on the CME Group's New York-based Comex exchange.
The LME's management has tried before to increase fees, only to back down in the face of stiff opposition from the exchange's members, who are also its shareholders. A new owner, however, should have plenty of leeway to jack up fees without driving away business. With a static cost base, that increase should translate directly into higher profits.
What's more, a new owner will also be able to make significant cost reductions. At the moment the LME operates an expensive trading floor. Although the membership is quick to defend old fashioned open outcry trading, closing the exchange floor would yield big cost savings and experience in other markets shows that brokers are quick to make the transition to wholly electronic dealing.
Analysts believe this combination of fee increases and cost cuts could push the LME's profits up almost five-fold compared to the 2010 figure. That would put the LME on a price to earnings ratio of between 20 and 30, a similar valuation to HKEx's own shares.
On top of that, the LME offers some enticing growth opportunities. At the moment the LME contracts out its clearing to a third party provider. Setting up its own clearing house would add a sizable new income stream.
To see the potential, just look at HKEx, which generates a third of its revenues from clearing and settlement fees and from managing the margin payments customers deposit with its clearing house against outstanding futures positions.
And finally there is the possibility that HKEx would be able to generate extra volume for the LME's contracts by offering greater ease of trading in the Asian time zone and perhaps by opening a warehouse on the mainland to attract more Chinese end-users.
As Monitor explained last week, securing the approvals necessary for a mainland warehouse will be tricky in the face of resistance from the rival Shanghai Futures Exchange, which offers metal futures contracts to onshore investors.
Even so, factoring in the potential for fee increases, cost savings from closing the trading floor, and a new revenue stream from clearing operations, the LME looks a lot less expensive than the three figure price to earnings ratio our sceptical reader quoted.