Real work begins after gaining the LME

Buying the metal exchange makes sense, but some analysts believe the future is unknown because of falling commodity prices

PUBLISHED : Friday, 16 November, 2012, 12:00am
UPDATED : Friday, 16 November, 2012, 2:47am

Hong Kong Exchanges and Clearing's proposed takeover of London Metal Exchange could well be the quickest way for it to diversify but it is also the biggest gamble the local bourse has ever taken.

However, it was hardly a surprise to brokers, who link the move to HKEx chief executive and former investment banker Charles Li Xiaojia's penchant for deal making.

The June deal for £1.39 billion (HK$17 billion) in cash marked the HKEx's first overseas acquisition and the biggest expansion in its history.

The deal has the approval of LME shareholders but is still pending clearance by the British regulator, the Financial Services Authority.

Just by looking at the target, it is difficult to deny the attractiveness of the LME as it handles more than 80 per cent of world trade in industrial metal futures, setting global prices for metals from copper to aluminium to nickel. It handled a record US$15.4 trillion worth of contracts last year.

The acquisition, if it goes through, would make HKEx the owner of the world's largest metal exchange overnight, helping HKEx serve mainland companies that are the world's biggest commodities buyers.

Turnover and new listings at HKEx have fallen this year, resulting in a 19 per cent profit drop in the third quarter and a 16 per cent profit drop in the first nine months, compared with the same periods last year.

Going by Li's blueprint, buying LME would allow the HKEx to step into commodities trading - uncharted territory for the local exchange.

Kelvin Wong Tin-yau, chairman of the Hong Kong Institute of Directors, welcomed the move to buy the LME.

"When stocks are doing well, commodities usually don't, and vice-versa. For the HKEx to run both a stock exchange and a commodities exchange is like a hedging business model through diversification," he said.

The acquisition has, however, been questioned by many brokers and analysts, concerned the high price tag may hurt HKEx's profits in the near term. The acquisition price is 180 times LME's profit last year.

"Diversification is good but the price is just too high," said Kenny Lee Yiu-sun, chief executive of First China Securities.

Li, however, defended his choice in August, saying: "Any transaction has a price and involves taking some risks. The biggest risk for the HKEx is us sitting there and doing nothing."

Stephen Sheung, investment strategist of SHK Private, has issues with the timing of the deal, more than the price.

"Had the acquisition been made 10 years ago, it would be a smart deal as commodity prices have risen substantially in the past 10 years in lock step with the demand from emerging markets," Sheung said.

"But now China is expecting a slowdown and is trying to put a brake on its infrastructure projects. Resources-rich countries such as Australia and Canada also believe the mining peak has long passed.

"The HKEx may well be entering the commodities market at the wrong time. As such, the acquisition price looks really steep," he said.

The deal won't be solely funded by the exchange's own cash. In June, it said it would borrow £1.1 billion and the bourse issued bonds last month to raise funds.

Brokers believe it will issue shares next month to help finance the acquisition.

Brett McGonegal, executive managing director and chief executive of Reorient Financial Markets, said merging the HKEx and the LME makes good business sense.

"Exchange mergers often succeed primarily on synergies and economies of scale. The link-up makes sense as the HKEx has been a popular listing venue for many natural resource and commodities companies, thus there are theoretical synergies," McGonegal said.

"The real judgment would come in terms of planning and execution. If this is a financial investment, I think people will be lukewarm to the prospects. But if this purchase is the beginning of a major link-up and [the creation of a] seamless trading platform and process, then I believe it is a viable, positive deal."

But he warned that the two exchanges now trade with different methods and platforms and could create a single platform only after a substantial upgrade in each.

The LME still uses the so-called open outcry trading, in which traders use hand gestures and call out prices.

The HKEx has promised to keep its current trading method unchanged in London until at least 2015.

The HKEx will need to hire new people to handle commodities trading.

A Barclays report issued last week noted that if the exchange continues to hire people, its profitability could be affected in the near term.

"I believe many people will predict this merger will cause a lot of hardship. The cross-border, time-zone issue is only a small part. The business cultures are different and the headwinds are enormous," McGonegal said.