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CME Group Inc. (NASDAQ:CME)

Citigroup US Financial Services Conference

March 06, 2013 10:35 am ET

Executives

James E. Parisi - Chief Financial Officer and Senior Managing Director of Finance & Corporate Development

Analysts

Donald Fandetti - Citigroup Inc, Research Division

James E. Parisi

Thanks, Don. And good morning, everyone. Thanks for inviting CME to present at the conference. Thankfully, I have a very thorough executive assistant who made sure that I got out here on Monday evening to beat the snowstorm out of Chicago. And as a result, I didn't have to shovel my driveway, so thank you very much, Don.

Today, I'm going to touch on some background information. Here's the forward-looking statements and Safe Harbor language, take a look at that. Today, I'm going to touch on just some background information on CME Group, for those of you who are less familiar with our company and our business model. Then I'll talk about the performance of each of our product lines, and then wrap up by talking about some of the growth opportunities that we see in front of us.

We are a company that's over 100 years old and very proud of it. And over our long history, CME has innovated a unique set of products and platforms. These assets actually situate us very well as a key component of the U.S.'s, and increasingly, the world's financial infrastructure. The combination of deep liquidity across a broad array of asset classes, as you'll see in just a bit, coupled with our world-class clearing platform and our distribution to over 150 countries around the globe through CME Globex, really translates into a business that benefits from network effects and that also has high barriers to entry.

The nature of our business model is one in which there's a high degree of operating leverage. We basically operate off a fairly fixed-cost base, charging a transaction fee for every contract processed through our markets. And because of this high degree of operating leverage, the very next contract that trades through our market comes to us at a very high margin and enables us to generate high operating margins generally and significant cash flow.

Even in a tough year like last year, where our volumes were down, let's say around 15% versus the prior year, we still posted an operating margin of about 58% and we returned $1.2 billion of cash to our shareholders, and we did that through a pretty novel approach with our dividend policy.

Let me describe that a little bit. Our current dividend policy is one where we are looking to return on a regular quarterly basis, about 50% of the prior year's cash earnings, we returned through our quarterly dividend in the current year. Then at the end of the year, or beginning of the following year, we'll take a look back, we'll say how much excess is now sitting on our balance sheet that we don't need to invest back into growth opportunities, or that we don't need to hold, use on bolt-on acquisition and such, and we'll return that to our shareholders. And we call that our variable 5th dividend, and we've been pretty successful with that, returning $0.60 a share for 2012 and then we accelerated the 2013 dividend into the end of 2012 as a result of tax uncertainty. So what we're doing is returning every dollar of excess capital to the shareholders and we've got a process in place to achieve that year after year. Even while paying this very healthy dividend, we continue to invest in growth opportunities, and I'll describe those a bit later in the presentation.

The overlapping circles on Slide 4 represent the unique product and platform combination that we've built at CME. In particular, we provide our clients with the broadest array of products under one roof. And there's a nice balance, you can see on here, in terms the revenue that we're generating across the 6 major product areas at CME. These product areas include: foreign exchange, equity, interest rate, energy, agriculture, commodities and metal.

So we're not -- we not only offer our customers this world-class liquidity and a broad array of products where they can efficiently transact their business, but this diversity also provides our customers with opportunities to more efficiently operate their business and, increasingly important, allows them to conserve capital as they realize portfolio inefficiencies in the one-stop shop that is CME Group. We continue to focus on providing our customers with the tools they need to optimize their business. This focus of ours improves the customer experience and, hopefully then, their loyalty and provides us with opportunities to generate revenue as we cross sell products and services to them.

On Slide 5, you can see that we faced some volume headwinds in 2012, driven primarily by a lack of volatility across our markets. We view this as a cyclical phenomenon. And there's some early evidence in 2013 that volatility is creeping back into the equation, resulting in growing volumes and open interest. You can just look at the growth in volume so far in 2013 versus the second half of 2012. We've so far 12.5 million contracts a day transacted through the first part of this year versus 10.5 million was the average for the second half last year. In fact, if you look at February, we had a really nice month, as I said, we saw some – a little bit of volatility in the equity markets in addition to some volatility across our other markets, our other asset classes, resulted in about 13.7 million contracts a day in volume in the month of February, so pretty strong results for us.

Here on Slide 6, you can see that the increase in open interest was pretty spread across the asset classes. I'm starting on Slide 7, I'll touch on each of the asset classes beginning with agricultural commodities. When you think about CME, we are the world leader in terms of the agricultural benchmark listed in our markets. We added to this stable of benchmarks late last year when we acquired the Kansas City Board of Trade and our hard red winter wheat contract. So far, the integration is going really great and their contract volume, in that particular product, was up 31% versus the same period last year.

We continue to look at ways to leverage our leadership position in this category around the globe. And when you think about macro trends, as the middle class emerges and grows in developing economies around the globe, they demand more and more protein in their diet and that demand will continue to increase as we move forward and this is a long-term bullish opportunity in our agricultural commodity asset class.

On Slide 8, you can see how our metals market has been performing. Notwithstanding the dip in the second half of 2012, there's a general upward trend in volumes since the beginning of last year. Construction and manufacturing around the globe has certainly contributed to strong volumes in our copper, palladium, platinum contracts. And we've also benefit on the precious metals side in terms of our gold and silver contracts from 2 somewhat opposing forces. One, when there's distress, any distress, in a major economy around the globe it causes flight to safety. One of the investments that folks look at in that flight to safety is – are precious metals, so we benefit there. On the flip side, as the economy restores and forges ahead around the world, the specter of inflation will start to rear its head and people's perceptions of that will increase and they'll look to gold and silver as hedges. So again, positive for our contracts.

On Slide 9, you can see how we've done in our energy business. While volumes are healthy, they've been under some pressure in the past year, really due to continued low volatility, very low prices of natural gas and infrastructure issues that you've all read about, I'm sure, in the press. So we're in and around Cushing, Oklahoma, the delivery point for WTI. The good news for us is, in the long run, is that the U.S. is still the largest consumer of energy in the world, will be a very large consumer of energy for decades to come. And now, due to the new drilling techniques and whatnot that we all read about also, it's apparent that CME is going to become one of the largest producers in the world of energy. So these all are, I'd say, very positive for our WTI and our natural gas contracts. We're also working on providing choice to our customers and capital efficiencies in our crude contracts. So in addition to our successful WTI product, we're also now listing a Brent contract, where we've gained a little bit of traction already. And we also have a -- we've also acquired about of 50% of the Dubai Mercantile Exchange and what they have is an Omani sour crude contract that appeals to a customer base in Asia, and we're looking to develop that over time.

Slide 10 shows that our equity franchise volumes have been a little lackluster over the past year, but this is driven, again, by low volatility in the equity markets and the significant equity outflows in the industry over the last several years. On the positive front, there are some early signs these trends may be leveling out and reversing in early 2013 as we've seen about $33 billion of inflows into actively managed equity funds in January and February, and we've seen some small volatility spikes in February that drove increased volumes to our platforms. We're also leveraging our equity franchise around the globe to partner with other exchanges with various cross-licensing arrangements. And with the signing of the Dow Jones/S&P joint venture agreement mid-last year, we're also locking in some important IP in this -- or we have locked in some important IP in this product set going forward.

FX volume, shown here on Slide 11, has been on a little bit of a tear since hitting a low in October of last year. This is an asset class where it appears we're picking up some volumes from the over-the-counter market. An indication of this is if you look in December, you look out at the notional value traded on CME's -- on CME Globex in our FX product line and you compare that notional value to the largest OTC platforms out there, we outpaced them in the month of December. It was the second month we did that in 2012.

Given the breadth of the FX contracts available to trade on Globex from more recently listed renminbi contract to the euro currency, we feel that CME is really well positioned to benefit from changing economic fortunes and interest rates around the globe. We're also going to leverage this FX expertise in our European futures exchange, the one we're establishing in London, where these will be the first contracts that are listed on that exchange when it opens later this year.

With respect to our interest rate product line, you can see what -- that we made some great strides off the lows that we hit towards the end of 2012. With just a bit of uncertainty around rates recently, we've seen a strong uptick in volumes and open interest. We've seen -- we've set the new record on the longer end of the curve with our treasury product, kind of interesting. As we've gone through meetings over the past year or 2 where we sit and we talked about the headwinds in the interest rate area for us, folks often asked us the question, "Are you going to be able to get back to record levels?" and here's evidence that, yes, it's obviously very achievable having hit a new record in treasury contracts this month.

So while the last few years have been challenging due to the low volatility and low overall rates across the yield curve, I think out of this adversity has come some opportunity and innovation that we've driven. So if you look, since 2010, the products that we have created and innovated in the interest rate product line have resulted in about 300,000 contracts a day of volume today. In my tenure in the industry, this is one of the -- probably the best new product introduction stories I've ever heard. And if you applied just an average interest rate, rate per contract to that, it's somewhere in the neighborhood of $30 million to $40 million a year of additional revenues.

In the intermediate and long term, I would expect that the improving economy and increasing uncertainty around both the long and short end of the curve are large positives for this franchise. In addition, I think that this product line stands to benefit from the migration of non-cleared OTC interest swaps into clearinghouses, and potentially, substitution of futures contract for some of those OTC products. And we'll talk a little bit about that in a moment.

So on the next few slides, I'll highlight a couple of areas where we see broader opportunities for growth across the company. Over our long history as an exchange, we've been fairly North American-centric and focused. Over the last several years, we've undertaken to broaden our focus out to the global customer community. Given the nature of the Globex network, the more customers we can add from around the globe, the more benchmark product that we can add around the globe, the more self-reinforcing that network is. We've invested in partnerships around the globe to expedite our ability to penetrate these customer bases and we've also invested in our teams. We've added about -- we've got about 40 people on the ground in Asia spanning products, sales, research, business development, et cetera, to go out there and attract -- be the feet-on-the-street and attract more customers and we continue to grow that office. We have also well over 100 people in our European office doing the same thing. And we have smaller representative offices in other locations around the globe.

Additionally, we've invested in the new clearinghouse, as I mentioned earlier, a new exchange in London, the clearinghouse is up and running. Today, it's clearing over-the-counter commodities products, but it's set to clear OTC interest rate swaps in the not-too-distant future. And the exchange that we're setting up there is expected to launch in the second half of the year. All this is with one goal in mind: it's to continue to provide opportunities for customers around the globe to benefit through their use of our markets and clearing facilities.

We've seen some success over the last several years, in that we've got about 28% of our Globex revenues today are coming from outside the U.S., with the bulk coming from Europe. And you can see that here, on a product-by-product basis, that most of the business is coming from Europe across the products, with a little bit more share for Asia in the metals business. To me, this just shows the great opportunity that's out there when you think that we're, what, 33% on metals going down to 14%, 15% on the commodity side in terms of the penetration outside the U.S., and again, most of that coming from Europe. Very large opportunity for us to grow this penetration of the non-U.S. customer base going forward.

And when you think about it and over the last, call it, 20 or 30 years, the developing or developed nations really came up the curve in terms of using derivatives. You're starting to see that more and more in the developing nations where they really have a penchant for using derivatives and moving up that learning curve much faster than the developed nations had because they have the blueprint in front of them. So also, as we see that middle class grow around the world, we expect that there'll be more demand for investments going forward. Again, these are all trends that are all long-term positives for CME Group. And we'll continue to focus on providing the great service and great solutions for our global customer base.

So only a few more slides to go. The last opportunity I want to touch on, which I've already alluded to, is the OTC clearing opportunity. On this chart can see that interest rates -- the interest rates swaps, OTC market represents about 83% of the total OTC financial OTC market and as measured by notional value outstanding and it dwarfs what's reflected in the exchange-traded markets in terms of outstanding.

But come March 11, just a few days away, the largest players in the interest rate swap market that represent the majority of the business are now going to be required to put their -- clear their transactions through an OTC swaps clearinghouse. And we've been investing for some time in our clearing capabilities in this regard and now have 23 intermediaries that are hooked up to CME, and we've got 60 firms that have market participants that have cleared trades with us in advance of the mandate coming in, so they're getting ready. One of the areas that we've just -- one of the new product lines that we just put out there is OIS swaps, just listed those earlier this month, and we're seeing already some early good traction in those products.

As with any offering, we're going to meet our customers' needs in the best way possible. We offer 3 ways for customers to get the exposures that they traditionally have sought in the OTC market. First, they can continue to do business the way they have and transact in the OTC market and then put it up for clearing at CME's clearinghouse. Alternatively, they can use our existing products like euro dollars and treasuries to get some of the exposure, the rate exposure and duration exposure that they're looking for. Or thirdly, they can use some of the products that we've innovated recently. So in the work with others, we've developed the deliverable swaps future. And what this does is it gives a very similar -- it's very similar in terms of the exposure that you would get to with over-the-counter swaps. It actually ends up -- if you hold it through expiration, it's delivered you an over-the-counter swap, you don't have hold it through expiration, obviously you can continue to roll it.

So we're looking for all different ways to meet that customer demand. When we think about this OTC opportunity, we do believe that we have a significant competitive advantage versus others. No one that's out there today that has a viable interest rate swap clearing facility has the breadth of futures, open interest, that CME Group has in interest rate products. That means we can provide something to our customer that others cannot. This is a significant opportunity for capital efficiencies.

Today, we have the ability and authority to cross margin our interest rate futures with interest rate swaps for both health and customer business. This, in some cases, results in capital savings of up to 90%. And if you think about it, the capital savings can be even greater if customers who choose to use futures instead of OTC product, they'll get a much better capital efficiency even then. And this is a very viable alternative, using the futures markets instead for those who are not necessarily looking for a specific hedge, but for a more general duration exposure. So in any of these alternatives, CME Group stands to profit while providing very efficient solutions for customers.

So I really think that CME has been built on a strong foundation of innovation; innovation of products, market structures and platforms. And this innovation is alive and well today, and as a result, we will continue to capitalize on profitable growth opportunities for years to come.

So with that, I guess, we can open up for some questions.

Question-and-Answer Session

Donald Fandetti - Citigroup Inc, Research Division

Yes, why don't we move to Q&A. I'll go ahead and kick if off with a question. Jamie, obviously, there's a high profile M&A deal in the space today. I know we've talked over the years around deals and all the exchanges seem to talk to each other that far for the course. But how does that deal, as you had time to absorb it, how does that impact your business, if any, and do you need to make a big acquisition? I know over the last few years you sort of have played down talk of big deals, and if you could just sort of talk a bit about that?

James E. Parisi

As I and as we think about the transaction that's been announced between NYSE and ICE, today, we all compete based on our -- product by product. And obviously, each exchange has their strong suit in terms of each product that they -- where they own liquidity. And so as we look at it, the fact that, that liquidity pool may be owned by a different player today, isn't that big of a change in the competitive dynamic for us. In terms of M&A, we are -- we have all the right pieces in place, we feel. We're not compelled by this transaction to go out and do anything new. We continue to focus on our business, focus on the assets we have and leveraging those going forward. That said, if a great opportunity were to arise where we can create shareholder value through some sort of M&A opportunity, we'll certainly take a look at it to see if it makes sense in that context.

Donald Fandetti - Citigroup Inc, Research Division

Okay. All right. Why don't we open it up for questions in the audience? I'll go ahead and...

James E. Parisi

We've got one.

Donald Fandetti - Citigroup Inc, Research Division

We've got one in front here.

Unknown Analyst

I've got a question, were you willing to comment about the reports about yourselves and Deutsche Boerse? What was really going on with the approaches to Deutsche Boerse? I'm not quite sure what to make of these papers. I'm not sure what you said, maybe I've missed it.

James E. Parisi

Yes, we don't comment on speculation out there in the market around any particular M&A rumor that's out there. So I'll just say what I already said, and we're not -- we don't feel compelled to go out and do any particular M&A deal as a result of what's going on today in the markets, and we feel we've got all the right assets in place.

Unknown Analyst

I found this data so compelled, but I can see you've got all the right assets. I'm still -- I can see why you're not compelled and why you -- it's still slightly surprising that the report says it.

James E. Parisi

I can't control the speculation that's out there.

Donald Fandetti - Citigroup Inc, Research Division

Any other questions in the audience? Over here, Matt?

Unknown Analyst

The deliverable swap future launch, I can't remember the exact date, but now we're several months into it. Can you talk a little bit about the open interest, where it sits today versus sort of what the internal bets were at the time? Because I'm sure there were a few. And then what are we seeing in the way of characteristics of the participants? Because I know you certainly had thought about that ahead of time, had some sort of market participants sort of preloaded, to some extent, the dealer community, et cetera. What are we seeing from new folks coming in above and beyond those that were there by design?

James E. Parisi

So first on the deliverable swap futures, I think it's in line how we expect it to go. It's going to be somewhat slow-going at first, but I think, so far, we've already developed about 20,000 contracts of open interest. There's a lot of interest in it from customers in this market, so there's a lot of chatter back and forth with us about the benefits of it and how it can be used, and so we're very encouraged by that. When we rolled it out, I'm sure you heard us say that it's -- we had a webcast where it was subscribed far beyond any webcast has ever had for any new product or anything that's happened at CME, so -- over the many years. So I think it's still -- it's going as well as we could have expected at this point and we look forward to continue to grow. When you think about the different phases that are out there in terms of the mandate and at that second phase, there's a large number of firms that will be impacted, right? In the first phase here in March, the smaller number that represents a larger portion of the overall business. Come June, it's a larger number that represents a smaller number -- a smaller amount of the business. But if there's difficulty or if there's -- if any of the – if the intermediaries are more choosy in who they're bringing through into that second phase, there's always the opportunity for us to use the deliverable swap future and other futures contract meet that need that might not be met otherwise. So very encouraged there, I'd say. And your other question, remind me?

Unknown Analyst

So we talked a little bit about the participant -- characteristics of the participants that are involved in the marketplace beyond the initial dealers that were involved, are we seeing anyone new yet?

James E. Parisi

You're seeing a very large -- everybody that required in the first phase, you're seeing them line up and get ready operationally -- operationally ready, as I said, we've got 60 different market participants that have posted some trade -- or some trades to the clearinghouse already in advance of the mandate. So large hedge funds, et cetera, that have to be there for that mandate. And even some of the folks who are in the second tier have been testing with us and whatnot. So it's, I'd say, going to plan and we'll see how that -- getting through the first -- getting through that first wave, we'll see how that big second wave goes and we'll talk more about that as that develops.

Donald Fandetti - Citigroup Inc, Research Division

I think we have a question up here.

Unknown Analyst

Could you comment on some of the headlines and scrutiny on LIBOR and what the potential impact would be to your dollar complex?

James E. Parisi

Sure. If you look at -- right, there's been a lot of headlines around LIBOR. But our view is that LIBOR will continue on as the benchmark. It is so embedded in the everyday financial landscape here and abroad that it would be very difficult for that to go away. I think you saw some of the commission that came out in the U.K., they've come up with some suggestions around it to improve how it's calculated and improve the resiliency of it and the reporting of it. So we're very confident that those sorts of recommendations will be put in place and that LIBOR will continue to stay for us. Now that said, you think about CME and our -- we've got the largest stable of interest rate products of anybody, so we've got a great expertise, obviously, in that area. So we'll always have backup plans and ways to address it if something were to happen, but our view is not that.

Donald Fandetti - Citigroup Inc, Research Division

Any other questions in the audience? I'll jump in. Oh, right there.

Unknown Analyst

So on the energy complex, you couldn't just talk about the state of play between yourselves and ICE and how that's developing and whether the – you listed the Brent contracts, and they -- and obviously the pipelines are opening up in the West, how that's going to play out?

James E. Parisi

,

Yes. Great question. So when you look at the WTI crude versus the Brent contract, obviously, there's infrastructure issues around Cushing that have weighed on WTI oversupply there. But you've seen articles recently, too, where there's -- not all is perfect in the Brent world either, there's pipeline disruptions and questions around the composition of Brent. So all that will be addressed by the market going forward. One of the nice -- when you saw -- it was a little test, right, when you saw the Seaway pipeline capacity open up further in January, I think it was around January 11 or so, you saw a nice pickup in WTI volume. You also saw the spread narrow, but then there was issues at the other end of the Seaway pipeline down by the Gulf, the spreads opened back up. But I think it's a sign that as the market comes in and addresses the supply issues in and around Cushing, it'll -- those markets will come back in line with the Brent market, assuming that Brent isn't off as a result of some of the issues I touched on. So I think it's positive. And if you look over the timeframe since that mid-January through now, I think we've been -- actually, WTI's been out-trading the Brent contract over that period of time. So again, another positive for us.

Donald Fandetti - Citigroup Inc, Research Division

Jamie, as we're getting closer to the swaps clearing, rules kicking in, have you gotten increasingly more positive on the sort of futurization or -- as you've seen things develop? And then, can you remind us how the ramp up might look from the clearing volumes just given the staged implementation of some of the rules?

James E. Parisi

Sure. Yes. I think we have grown incrementally more positive on the opportunity for people to substitute futures for their OTC positions. We're hearing it anecdotally as we're out talking with folks, they are using our markets more. You're seeing -- we've seen, as I showed on the slide earlier in our interest rate quadrant, we've seen volumes increase. I can't say how much of that is tied to that, but there's a sense that some of that is directly related to that. We're seeing the pickup in open interest on the deliverable swap features. So all positives on that front and I think a great good opportunity again for CME. In terms of the ramp up going forward, it's very difficult to say because it's such new ground for us. We'll look to see how March 11 goes. Remember, it's not -- you're not required back load, you're required to put your new swaps in, so we'll see how that plays out over time. And then with the -- you've got the June date and then the September date for the last players there. So I'd expect this year to be somewhat of a transition year, as people feel it out and try to understand the best way to transact their business. And I look at it as an opportunity for us to push and sell on the futures side, as well as provide that service, that OTC clearing service that people are looking for.

Donald Fandetti - Citigroup Inc, Research Division

Okay. Maybe the last question is, if you could talk a little bit about the general regulatory environment? I mean, it seems to be a pretty decent tailwind for the sector and for CME, is there anything else out there, whether it's high-frequency or any those types of issues or concern you on the reg side?

James E. Parisi

There's nothing -- I'd say, there's nothing overly concerning. And just as a general point, if you look over the last several years and everything that's come out on the regulatory front, and how we have navigated in those regulatory waters and worked with our -- the regulator and other participants in the industry, I think that we've come to a very decent place in terms of a lot of the issues out there. There's always going to be an issue or two that are being worked on. But I think, by and large, we've done a good job navigating those waters. You brought up HFT, I think we're doing well there. I think there's a pragmatic approach that's being taken there as it relates to HFTs, particularly in the futures markets, where for a very long period of time, we've got a lot of protections already embedded in our system at CME that the cash side of the market is looking at mimicking on their side. So I think we were well positioned and well prepared for what's coming down the pike there.

Donald Fandetti - Citigroup Inc, Research Division

One other thing on high-frequency, I know recently CME cited slightly less interest from some of the high-frequency firms on co-location. We've seen some of the reports of those high-frequency firms having less revenues and profits. And can you talk a little bit about if that's impacting you at all in terms of your volumes? Or if that view has changed on co-location at all?

James E. Parisi

On co-location, what's happened is, it was our first year, people had to sign-up a year in advance for the space that they wanted for the coming year. So I think people tended to be a little conservative and signed up for a little bit of extra space. They want 3 years' worth of experience. Obviously, activity was down a little bit last year, so that probably also informed how they're going to -- the space that they were going to lease going forward. So they shrunk their footprints basically. We're not seeing a decrease in the number of customers accessing our co-lo, in fact, we saw a little bit of an increase. In terms of the bigger question around the health of the high-frequency guys in our market, I can look at the data and tell you that, from the proprietary trading perspective, the percent of volume that they're doing today is very similar to the percent of volume that they've been doing for a year or 2 at least. So we're not seeing a big move there. The movements in the markets are causing all boats to rise and fall together.

Donald Fandetti - Citigroup Inc, Research Division

Got it. Good. All right, I think with that, we're out of time, and so we'll conclude. Jamie, thank you again for your time today. I appreciate it.

James E. Parisi

Thank you very much.

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