Founded as the Chicago Butter and Egg Board in 1898, CME Group (CME) has grown into a substantial publicly traded futures exchange operator. CME is the largest derivative exchange operator in the world and handles 90% of all futures trading in the U.S. Much like a toll collector, CME charges a transaction fee for trading and clearing futures contracts on their exchanges. CME operates the Chicago Mercantile Exchange, the Chicago Board of Options, the New York Mercantile Exchange, and the Commodities Exchange. CME also owns the various Dow Jones Indexes.
From their website:
Serving the Risk Management Needs of Customers Around the World - Building on the heritage of CME, CBOT, NYMEX and COMEX, CME Group serves the risk management needs of customers around the globe. We provide the widest range of benchmark futures and options products available on any exchange, covering all major asset classes. Our collective vision is one of ongoing global growth, innovative product development, continually enhanced technology and the highest level of service available on any exchange.
A list of futures and options contracts traded on their various exchanges can be found here and include Wheat, Nonfarm Payroll, Heating Oil, Gold, and Foreign Exchange. The largest revenue generator for CME is their Interest Rate futures and options.
According to Trefis.com, the most important product sectors are Interest Rate Contracts, Energy Contracts, and Commodities and Metal Contracts. The graph below outlines Trefis estimated share value by product segment:
Click to enlarge images.
There are two drivers of future earnings growth -- contract volume and transaction fees. The two largest product components of CME have been under pressure from competitors with several upstart attempts to establish a foothold in the dominant positioning of CME. Over the years, the firm has successfully defended its Interest Rate contract position, with the latest entries from crosstown rival Eris Exchange and NYSE's Liffe U.S.
Contract volumes are reported monthly and have been up and down this year -- but mainly down. Total year Interest Rate contracts are expected to decline from an average of 6.01 million contracts per day to 5.6 million contracts per day. Trefis expects this year to be a trough with Interest Rate volumes picking up and offering growth over the next three years of about 9%. As interest rates rise over time, the need to hedge the risk becomes more important and more desirable. One of the positive outcomes in a rising interest rate environment is the need to hedge and this directly benefits CME. Over the next three years, Trefis anticipates fees to be relatively flat at $0.48 per Interest Rate trade.
Energy contract volumes are expected to be flat in 2012 at 1.6 million contracts per day, but start to climb by 6% a year in 2013. As the economy improves and the price of energy reacts by increasing in price, contract volumes are expected to improve as well. Energy transaction fees have been on the decline from $1.75 per trade in 2008 to a current $1.45 and a stabilizing to slightly rising pricing environment should accompany improved volumes.
Commodities and Metals contracts have followed the same volume and pricing trajectories as the other products. 2012 volumes are expected to average 1.27 million per day, down from 1.47 million and pricing will be about flat at $1.42 vs. $1.39. Over the next few years, Trefis anticipates flat fee growth with slightly higher volumes.
CME has a growing international presence anchored by partnerships with 12 different exchanges, such as the cross-investment and futures development programs with Brazilian exchange operator BM & FBOVESPA and the joint venture with The Dubai Mercantile exchange to offer the Middle East's first local future exchange. A more detailed description of each of CME's relationships can be found on their website here. Here is a map of international strategic programs from CME's website:
Earnings per share in 2012 are expected to be lower than in 2011, with this year's anticipated EPS of $3.04 vs. last year's $3.41. With an anticipated rebound in contract volume and an improving fee structure, consensus earnings estimates are for $3.36 in 2013 and upward of $3.65 in 2014.
CME has generated a five-year average return on invested capital of 6.3% and consistent gross margins of between 60% and 65%. Long-term debt stands at $2.89 billion, almost equaling annual revenues of $2.99 billion. There are 333 million shares outstanding and CME has a market capitalization of almost $19 billion. S&P Equity ranking lists CME as B+, or average, for 10-year consistency in earnings and dividend growth.
In January 2012, management announced a change to its dividend policy. After going public in 2002, CME started paying a dividend in March 2003 with an annual payout the first year of $0.13 per share. This past January, management announced a new program of paying a quarterly dividend and an annual special dividend based on profitability. In 2012, the quarterly dividend was raised to $0.45 and the special dividend based on 2011 profitability was $0.56 (after a 5:1 stock split), for an annual payout of $2.36.
With uncertainty surrounding the 2013 tax rate on qualified dividends, CME announced this week the payment of the 2013 annual special dividend this year. The special dividend of $1.30 per share will be paid on Dec. 28 to shareholders of record as of Dec. 17.
At a quarterly rate of $0.45, which is consisting with the past four quarters, and the 2013 special dividend of $1.30, the annual current yield would be 5.6% -- rivaling utility yields. Not including the annual special dividend CME offers a yield 3.2%, also competitive with some utilities, especially historically lower-yielding gas utilities.
However, based on anticipated 2012 to 2014 EPS, CME's payout ratio would be 70% in 2011 ($2.36/$3.41) and over 100% in 2012 ($3.10/$3.04). With no dividend increase in 2013 and 2014, the payout ratio could fall back to 85% in 2014.
CME will exit 2012 with about $1.6 billion in cash and have sufficient on hand to fund $750 million in debt maturities scheduled in 2013. Operating cash flow for the trailing 12 months, as of Sept. 30, was $1.244 billion, and sufficient to cover an anticipated annual 2013 dividend payment of $1.032 billion (including the December 2012 payment), or $3.10 a share.
Based on the S&P Utility Sector ETF (XLU), the sector yields about 4.1%, with a dividend growth potential keeping up with inflation at about 3.0% to 3.5%. If investors expect the utility sector total return in the 8% range, capital appreciation could be in the 3.5% to 4.0% range.
CME's currently offers a 5.6% yield and an anticipated 6.0% to 10% long-term earnings growth rate. It would appear that the current payout ratio, while seemingly unsustainable at current levels, is not disproportionate over the short term. The current high yield may offset a potentially stagnant dividend payout over the next two years. As subsequent underlying earnings growth reduces the payout ratio, dividend increases in excess of the inflation rate would seem probable.
While seemingly obscure, an in-depth look at the CME Hurricane Index (CHI) may give a bit better insight as to the type of risk hedging CME offers. From an article in the CME company newsletter, Open Markets, dated Aug. 28, 2012:
In 2008, the year of Hurricane Ike, CME started listing hurricane products. Using publicly available data from the National Hurricane Center of the National Weather Service, the CME Hurricane Index (CHI) futures contract uses the maximum wind velocity and size (radius) of each official storm to calculate the potential for damage. The front contract expires when a hurricane makes landfall with the expiration pegged to the CHI. The contract tick size is 0.1 CHI point, which is equivalent to $100.
The product aims to meet the needs of both the derivative trading community and the insurance market while being easily understood by being simple to calculate and based on publicly verifiable data. In addition to insurers, other customers - such as energy companies, pension funds, state governments and utility companies -through use of the products are able to hedge their risk of hurricanes striking in the United States in five areas defined as the Gulf Coast, Florida, the Southern Atlantic Coast, the Northern Atlantic Coast and the Eastern U.S. CME expanded the instruments in 2009 with the introduction of binary options. Of the products available to hedge against hurricane-related risk, CME's product is one of the few that trades on an exchange.
Below is a 10-year share price chart with the 200-day simple moving average:
CME offers additional potential rewards as portions of the Dodd-Frank legislation are implemented. For example, there is movement to require OTC interest rate swaps be cleared through a third party, and CME is one of the largest clearinghouses.
One negative that should be watched by shareholders is the issue of insurance protection for futures traders in the case of default by the futures brokers, such as MF Global and Iowa-based Peregrine Financial Group. While CME has offered some limited protection to family farmers and ranchers in the wake of the MF Global fiasco, there are calls for the government to require a similar program those found in the broker-dealer industry. While thought to be expensive and originally opposed by CME, management is warming up to the idea as preferable to additional regulations. The impact on CME's profitability from these types of regulations is an unknown for the moment.
CME share price targets are currently in the high $50s to low $60s. While not a barnburner of potential capital gains, adding a 6% or higher annual share growth to a 5.6% yield creates an acceptable total return potential for income and dividend investors. If 2014 EPS is above $3.65, with $4.00 in sight, the market may reward CME with a P/E ratio about equal to its current 18, pushing price targets to over $70.
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Disclosure: I am long CME.