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Bottom Line

Dodd-Frank will push OTC trades to exchange-operators like CME Group (CME). 10-year trading volume CAGR is around 15%. Assuming 20% trading volume growth in 14E and 15E after (15%) and 5% volume growth in 12/13E, upside is low 70s and downside is low 50s assuming mid-single digit trading volume growth throughout. I see CME earning close to $4 in 2014. Upside price implies high-teen forward P/E multiple.

Business overview

CME Group is the holding company for CME, CBOT and NYMEX. CME Group also includes two clearing houses - CME Clearing and CME Clearing Europe. CME offers customers the opportunity to trade futures contracts and options on futures contracts of interest rates, equities, foreign exchange, agricultural commodities, energy and metals. The company also clears over-the-counter [OTC] contracts on interest rate swaps, credit default swaps, energy and agricultural commodities. Customers include professional traders, financial institutions, individual and institutional investors, major corporations, manufacturers, commodity producers and governments.

CME's products are executed through the electronic trading platform Globex, open outcry trading floors or privately negotiated transactions that are cleared and settled through CME clearing house. The clearing houses settle and guarantee every futures and options contract traded through CME's exchanges and OTC products like credit default swaps and interest rate swaps. The clearinghouse guarantee eliminates the need for customers to evaluate the credit of each potential counterparty or limit themselves to a selected set of counterparties. This flexibility increases the potential liquidity available for each trade. In addition, the substitution of CME clearing house as the counterparty to every transaction allows customers to establish a position with one party and then to offset the position with another party. Contract offsetting provides flexibility in establishing and adjusting positions and provides for performance bond efficiencies. The clearinghouse guarantee is a result of initial margins requirements for exchange-traded and over-the-counter products and daily mark-to-market on all open positions.

Trading volume and positive network effect drive the business model

Around 82% of revenue is clearing and transaction fees. For every trade that gets processed through the electronic trading system, physical trading floor or the clearing system, CME Group charges a fee. Clearing and transaction fees are calculated on a per-contract basis and revenue correlates with trading volume. Average daily volume is the revenue unit for CME Group. Rate per contract fluctuates with volume discounts, product mix (interest rate, equity, FX, agriculture, energy or metal), venues (electronic or physical outcry) and member/non-member mix. The Company is like a toll taker, providing the infrastructure and collecting fees along the way. The business model of CME group has tremendous positive network effects. The more customers trade at CME, the deeper the liquidity and the better transactional experience for all customers. As a result, more new customers are attracted to transact at CME group.

Most expenses do not fluctuate directly with changes in trading volume. Only licensing and other fee agreements and employee bonuses vary directly with trading volume. Most of the infrastructure and trade-processing technology spend are fixed cost.

Customer base is captive

CME has captive customers who make a living from bid-ask spread. This is because if customers are taking on a trade to make a spread, they would take an immediate offsetting transaction to eliminate any price risk. While collateral nets out on a risk basis within one clearing house so that customers can conduct numerous multi-directional transactions, collateral doesn't carry over between clearing houses. There is no cross collateralization between clearing houses. This non-fungibility, unlike equity exchanges, is another moat of CME Group's business model.

Acquisition history is a risk

CME Group scaled itself up through acquisitions, buying CBOT in 2006 and NYMEX in 2008. This gives the company a monopolistic position in U.S. Eurodollars and Treasury futures products. For example, ELX, an upstart rival backed by Deutsche Bank, Credit Suisse, Bank of America-Merrill Lynch and JPMorgan, tried to enter CME's market space through low cost. However, for most of 2012, ELX handled around 1 million contracts a month, less than the average daily volume at CME Group. Although the NYMEX and CBOT acquisitions give CME Group the monopolistic position and the KBOT acquisition help the company scale up its market share in agriculture commodity products, there is still risk that CME Group overpaid for these deals. Stripping out the cash performance bonds and guaranty fund contributions from the balance sheet, goodwill is a quarter of its asset.

Past announced deals (Successful and failed)

Date

Bid Size (MN)

Target

Target EBITDA (million)

Multiple

CME

Oct-06

8,000

CBOT

330

24.2

CME

Mar-08

9,000

NYMEX

424

21.2

CME

Dec-12

126

KCBOT

4.9 (est.)

25.7

ICE

Sep-06

1,000

NYBOT

30

33.3

ICE

Dec-12

8,200

NYSE Euronext

1,135

7.3

Deutsche Börse

Feb-12

9,530

NYSE Euronext

1,135

8.4

LSE

Jun-11

3,700

TMX

400

9.3

Singapore

Apr-11

8,800

ASX

480

18.3

K.C. Board of Trade (000s)

RPC

1.258

2011 Volume

6,000

Revenue

7,549

D&A

377

EBIT (60%)

4,530

EBITDA

4,907

Purchase price

126,000

EV/EBITDA

25.7

OTC migrating to a cleared environment is a tailwind for trading volume

Dodd-Frank implementation will push OTC trades into the exchange environment. OTC is a huge addressable market for exchanges-operator like CME to capture. Counterparty credit concern is one of the issues that customers look at when they decide to move their business to a cleared environment ahead of the Dodd-Frank mandate. About 10% of derivatives outstanding notional is on exchange traded environment, therefore, there is plenty of OTC greenfield for CME to capture.

The first impact of Dodd-Frank hit in February 2013, affecting the active hedge funds and the swap dealers. That's going to include mostly vanilla interest rate swap on major currencies. The second stage will be in May and impacts the non-dealer banks, the insurance banks and the regulation scales out through 2012.

Customers have the choice to either use OTC clearing services or shift their business directly into futures using deliverable swap future. Revenue opportunity for interest rate swap clearing is $5 - $6 per million notional on average. CME has already invested in the infrastructure to support OTC clearing.

Margin advantage and offsets between swaps and futures will drive the OTC migration

Within interest rates, CME offers OTC swap clearing, swap futures and interest rates futures. Clients can execute and clear the OTC swaps, convert into the swap deliverable futures or convert entirely to CME's interest rates futures. There are two types of cost savings: margin difference and margin offsets. Transparency in futures drives margin requirements difference between a swap and a future. Futures contracts have a one to two day requirement while swap requires five days. Margin offsets are resulted from combining OTC swaps positions with CME's Eurodollar and Treasury futures. Since CME has a monopolistic position in the interest rate futures market, the company is the only one offering margin offsets to capture incremental OTC swap business.

Buy-side clients, who have counter-party concerns, have been using CME's platform to clear OTC trades. If CME continues to win business on Dealer-to-Client trades, it becomes capital efficient for dealers to clear their inter-dealers OTC trades with CME as well. This is because for every one of pairs that the buy side does, there's an inter-dealer transaction attached to it. If the dealers aren't clearing on CME, they can't take advantage of margin offsets. Capital efficiencies become a bigger issue especially when Basel III kicks in.

Cross-margining is unique to CME Group, because it can't be replicated. Competitors can't offer lower price to get cross-margin because they need the open interest. As CME clears more OTC swaps, it becomes more capital efficient for clients to put their trades with CME. CME offers OTC swap clearing, swap futures and interest rates futures. One drawback of swap futures or interest rates futures is they don't have the customization and might not qualify for hedge accounting. CME also introduced a pricing discount for high-turnover swap traders who usually trade flat and don't require large amounts of initial margin.

The capital costs with Basel III on the banks will start to drive interest in more dealer-to-dealer trades. Capital efficiency on the deliverable swap futures vs. OTC swap is not only about the one-day versus five-day margin treatment, but also that these positions net down because they are futures. Cross margining relative to CME's Eurodollar and Treasuries futures starts in November 2012. The new capital rule will create bias for dealers to want to concentrate clearing in one clearinghouse because of capital inefficiencies of having collateral on hand at two different clearinghouses.

MF Global bankruptcy had a negative impact on the Futures Commission Merchants [FCM] model

CME has the dual mandate of regulating the futures brokers and operating the exchange. U.S. futures brokerages currently hold most of the money that customers put up to back their futures trades, earning interest on those funds while putting just a portion of the funds at clearinghouses like CME. The FCMs have made 40-60% of their income on this interest stream. Interest earned on customer funds held at a clearinghouse is returned to the FCMs. Futures brokers and clearinghouses each keep customer money at banks. MF Global, a FCM, bankruptcy has caused doubt over CME oversight over the FCMs.

There has been debate that CME should take over the role of futures brokers to restore confidence. Another suggestion is to change account segregation rules and segregate at the individual account level. CFTC has put OTC swaps on legal segregation but operational co-mingling. Moving that regulatory framework to futures would add extra cost. However, the incremental cost would be passed through to clients who want such additional protection.

In addition, there is a change in approach between Donohue and Gill on FCM bankruptcy. When MF Global went bust, Donohue dismissed MF as fraud and CME Group has nothing to do with the event. He focused on transferring accounts, releasing collateral and helping customers repositioned at other clearing member firms, while relying on trustees to retrieve the missing funds. When another futures brokerage Peregrine failed in Oct 2012, CME started immediate payouts to Peregrine customers. The status quo is here to stay and CME Group should be able to pass through any incremental cost from additional protection to the customers.

What are the bears saying?

The bear thesis focuses on 2013 earnings risks and stretched valuation. Bears argue that CME's core products (rates, index and energy) are weak with the lowest open interest in three years. Bears don't think the OTC opportunity will bring incremental benefits in the near-term and uncertainty around the OTC regulation will put pressure on average daily volume. Consensus expects low-single to mid-single digit volume growth in 2013. In addition, CME's P/E has re-rated +40% since introducing the fifth variable dividend, about 5 - 10% above the average P/E of 15x. Therefore, there is downside in revenue and P/E de-rating risk. The investment thesis for CME group should look beyond 2013 and OTC regulations and cost savings from margin offsets and differences are long-term tailwinds for the business.

Volume down 15% in 2012 versus 15% long term CAGR

(click to enlarge)

Assumptions for the income model

  • Assume flat revenue outside of clearing/ transaction fees
  • Clearing/ transaction fees (82% of revenue) driven by total trading volume and average rate per contract
  • Technology support services and occupancy costs are assumed fixed in the pro forma years
  • Other expenses are driven by percentage of revenue
  • Interest expense will decrease after debt refinancing
  • Key intrinsic value driver is the trading volume

Base case of low 70s:

2010

2011

2012

2013E

2014E

2015E

2016E

2017E

Average Daily Volume

12.2

13.4

11.4

12.0

14.5

17.3

19.9

22.9

Y/Y

18.6%

10.5%

-15.0%

5.0%

20.0%

20.0%

15.0%

15.0%

Downside case of low 50s:

2010

2011

2012

2013E

2014E

2015E

2016E

2017E

Average Daily Volume

12.2

13.4

11.4

12.0

14.5

17.3

19.9

22.9

Y/Y

18.6%

10.5%

-15.0%

5.0%

5.0%

5.0%

5.0%

5.0%

Income Statement:

Income Statement

2010

2011

2012

2013E

2014E

2015E

2016E

2017E

Clearing and transaction fees

2,486.3

2,710.9

2,371.5

2,458.0

2,949.6

3,539.5

4,070.4

4,681.0

Market data and information services

395.1

427.7

387.1

387.1

387.1

387.1

387.1

387.1

Access and communication fees

45.4

49.2

88.8

88.8

88.8

88.8

88.8

88.8

Other Revenue

76.9

92.8

67.2

67.2

67.2

67.2

67.2

67.2

Total Revenue

3,003.7

3,280.6

2,914.6

3,001.1

3,492.7

4,082.6

4,613.5

5,224.1

Transaction % of revenue

82.8%

82.6%

81.4%

81.9%

84.5%

86.7%

88.2%

89.6%

Average Daily Volume

12.2

13.4

11.4

12.0

14.5

17.3

19.9

22.9

Y/Y

18.6%

10.5%

-15.0%

5.0%

20.0%

20.0%

15.0%

15.0%

Total Volume (in millions)

3,078.1

3,386.7

2,890.0

3,034.5

3,641.4

4,369.7

5,025.2

5,779.0

Average rate per contract

0.81

0.80

0.82

0.81

0.81

0.81

0.81

0.81

Days used

253.0

252.0

253.0

252.0

252.0

252.0

252.0

252.0

Compensation and benefits

432.1

475.7

496.7

480.2

523.9

571.6

645.9

731.4

Communications

40.6

42.3

40.1

41.0

47.7

55.8

63.1

71.4

Technology support services

50.5

52.1

50.7

55.0

55.0

55.0

55.0

55.0

Professional fees, outside services and licenses

117.5

126.1

126.8

132.1

153.7

179.7

203.1

229.9

Amortization of purchased intangbiles

128.1

132.0

116.2

120.2

139.9

163.5

184.8

209.2

Depreciation and amortization

129.9

128.5

136.9

135.0

157.2

183.7

207.6

235.1

Occupancy & building operations

74.9

77.5

77.0

80.0

80.0

80.0

80.0

80.0

Licensing and other fee agreements

82.6

84.9

82.6

85.1

99.0

115.7

130.7

148.1

Restructuring/ Other

116.4

140.4

95.6

90.0

104.8

122.5

138.4

156.7

Total expenses

1,172.6

1,259.5

1,222.6

1,218.6

1,361.2

1,527.5

1,708.6

1,916.8

Operating Income

1,831.1

2,021.1

1,692.0

1,782.5

2,131.5

2,555.1

2,905.0

3,307.3

Operating margin

61.0%

61.6%

58.1%

59.4%

61.0%

62.6%

63.0%

63.3%

Percentage of Revenue

Compensation and benefits

14.4%

14.5%

17.0%

16.0%

15.0%

14.0%

14.0%

14.0%

Communications

1.4%

1.3%

1.4%

1.4%

1.4%

1.4%

1.4%

1.4%

Technology support services

1.7%

1.6%

1.7%

1.8%

1.8%

1.8%

1.8%

1.8%

Professional fees, outside services and licenses

3.9%

3.8%

4.4%

4.4%

4.4%

4.4%

4.4%

4.4%

Amortization of purchased intangbiles

4.3%

4.0%

4.0%

4.0%

4.0%

4.0%

4.0%

4.0%

Depreciation and amortization

4.3%

3.9%

4.7%

4.5%

4.5%

4.5%

4.5%

4.5%

Occupancy & building operations

2.5%

2.4%

2.6%

2.6%

2.6%

2.6%

2.6%

2.6%

Licensing and other fee agreements

2.7%

2.6%

2.8%

2.8%

2.8%

2.8%

2.8%

2.8%

Restructuring/ Other

3.9%

4.3%

3.3%

3.0%

3.0%

3.0%

3.0%

3.0%

Total Operating expenses

39.0%

38.4%

41.9%

40.5%

39.5%

38.5%

38.5%

38.5%

Number of employee

2,570

2,740

2,546

2,622

Comp per head

168

174

195

183

Y/Y

8.3%

3.3%

12.4%

-6.1%

Headcount growth

13.7%

6.6%

-7.1%

3.0%

Interest Expense

(140)

(117)

(132)

(142)

(82)

(82)

(82)

(82)

Interest and Invest. Income

42.3

36.7

38.7

35.0

35.0

35.0

35.0

35.0

Net Interest Expense

-98.0

-80.2

-93.5

-107.0

-47.0

-47.0

-47.0

-47.0

Interest Income % of cash

4.7%

3.4%

Income/(Loss) from Affiliates

-6.4

-4.3

30.7

Currency Exchange Gains (Loss)

6.0

-

Other Non-Operating Inc. (Exp.)

-8.6

-0.1

64.3

EBT Excl. Unusual Items

1,744.6

1,936.5

1,693.5

1,675.5

2,084.5

2,508.1

2,858.0

3,260.3

Merger & Related Restruct. Charges

-

Impairment of Goodwill

-19.8

Gain (Loss) On Sale Of Invest.

-2.2

Asset Writedown

-0.7

Other Unusual Items

-

EBT Incl. Unusual Items

1,721.9

1,936.5

1,693.5

1,675.5

2,084.5

2,508.1

2,858.0

3,260.3

Income Tax Expense

769.8

122.1

786.7

670.2

833.8

1,003.2

1,143.2

1,304.1

Net Income

952.1

1,814.4

906.8

1,005.3

1,250.7

1,504.9

1,714.8

1,956.2

Tax rate

44.7%

6.3%

46.5%

40.0%

40.0%

40.0%

40.0%

40.0%

Less: Minority Int. in Earnings

(0.7)

(2.1)

(10.4)

0

0

0

0

0

Net Income

951.4

1,812.3

896.4

1,005.3

1,250.7

1,504.9

1,714.8

1,956.2

Per Share Items

Diluted EPS

2.86

5.43

2.70

3.03

3.77

4.53

5.16

5.89

Weighted Avg. Diluted Shares Out.

332.5

333.8

332

332

332

332

332

332

Balance Sheet:

Balance Sheet

Currency

2009

2010

2011

2012

2013E

2014E

2015E

2016E

2017E

ASSETS

Total Cash & ST Investments

303

905

1,093

1,661

1,767

1,853

1,952

2,097

2,287

Total Receivables

281

298

289

268

270

314

367

415

470

Receivable % of sales

10.8%

9.9%

8.8%

8.9%

9%

9%

9%

9%

9%

Prepaid Exp.

21

Deferred Tax Assets, Curr.

24

Cash performance bonds

4,039

9,334

6,585

6,585

6,585

6,585

6,585

6,585

Other Current Assets

6,070

146

233

204

204

204

204

204

204

Total Current Assets

6,679

5,388

10,948

8,718

8,827

8,957

9,109

9,302

9,546

Gross Property, Plant & Equipment

1,285

1,300

1,398

1,364

1,514

1,689

1,893

2,100

2,309

Accumulated Depreciation

(546)

(513)

(576)

(640)

(775)

(933)

(1,116)

(1,324)

(1,559)

Net Property, Plant & Equipment

739

787

822

724

739

756

776

776

750

Depreciation % of sales

4.8%

4.3%

3.9%

4.7%

4.5%

4.5%

4.5%

4.5%

4.5%

Goodwill

7,549

7,984

7,984

7,567

7,567

7,567

7,567

7,567

7,567

Other Intangibles

20,229

20,494

20,353

20,029

19,909

19,769

19,605

19,421

19,211

Deferred Tax Assets, LT

Deferred Charges, LT

Other Long-Term Assets

436

394

654

1,825

1,825

1,825

1,825

1,825

1,825

Total Assets

35,651

35,046

40,761

38,863

38,867

38,874

38,883

38,891

38,900

LIABILITIES

Accounts Payable

47

52

31

42

45

52

61

69

78

Payable % of sales

1.8%

1.7%

0.9%

1.4%

1.5%

1.5%

1.5%

1.5%

1.5%

Accrued Exp.

148

-

Short-term Borrowings

300

421

750

750

750

750

750

750

Curr. Port. of LT Debt

19

Curr. Income Taxes Payable

15

-

Unearned Revenue, Current

5

-

Other Current Liabilities

270

250

241

241

241

241

241

241

Cash performance bonds

5,990

4,039

9,334

6,585

6,585

6,585

6,585

6,585

6,585

Total Current Liabilities

6,524

4,781

9,615

7,616.9

7,620

7,628

7,636

7,644

7,654

Long-Term Debt

2,022

2,105

2,107

2,108

2,108

2,108

2,108

2,108

2,108

Unearned Revenue, Non-Current

-

Pension & Other Post-Retire. Benefits

30

Def. Tax Liability, Non-Curr.

7,646

7,840

7,227

7,413

7,413

7,413

7,413

7,413

7,413

Other Non-Current Liabilities

129

192

188

220

220

220

220

220

220

Total Liabilities

16,350

14,918

19,136

17,358

17,361

17,368

17,377

17,385

17,394

Common Stock

1

1

1

3

3

3

3

3

3

Additional Paid In Capital

17,187

17,278

17,115

17,213

17,213

17,213

17,213

17,213

17,213

Retained Earnings

2,240

2,886

4,325

3,993

3,993

3,993

3,993

3,993

3,993

Treasury Stock

Comprehensive Inc. and Other

-126

-104

112

209

209

209

209

209

209

Total Common Equity

19,301

20,060

21,552

21,419

21,419

21,419

21,419

21,419

21,419

Minority Interest

-

68

73

87

87

87

87

87

87

Total Equity

19,301

20,128

21,625

21,506

21,506

21,506

21,506

21,506

21,506

Total Liabilities And Equity

35,651

35,046

40,761

38,863

38,867

38,874

38,883

38,891

38,900

Cash Flow Statement

Cash Flow

2010

2011

2012

2013E

2014E

2015E

2016E

2017E

Net Income

951.4

1,812.3

906.8

1,005.3

1,250.7

1,504.9

1,714.8

1,956.2

Depreciation & Amort.

129.9

128.5

136.9

135.0

157.2

183.7

207.6

235.1

Amort. of Goodwill and Intangibles

128.1

132.0

116.2

120.2

139.9

163.5

184.8

209.2

Total D&A

258.0

260.5

253.1

255.2

297.1

347.2

392.4

444.3

Other Amortization

4.9

4.9

5.3

(GAIN) Loss From Sale Of Assets

-

(9.8)

0.1

Loss On Sale Of Invest.

2.2

-

(78.8)

Asset Writedown & Restructuring Costs

20.5

-

19.9

(Income) Loss on Equity Invest.

6.4

4.3

(30.7)

Stock-Based Compensation

40.9

51.3

61.4

Tax Benefit from Stock Options

-

-

Provision & Write-off of Bad debts

-

21.7

Other Operating Activities

33.4

(656.9)

82.2

Change in Receivable

(28.7)

(13.2)

(0.3)

(2.6)

(44.2)

(53.1)

(47.8)

(55.0)

Change in Payable

6.1

(21.0)

11.2

3.3

7.4

8.8

8.0

9.2

Change in Inc. Taxes

12.4

(18.0)

71.9

Change in Other Asset/ Liability

48.9

(89.8)

(85.2)

Cash from Operation

1,356.4

1,346.3

1,216.9

1,261.2

1,510.9

1,807.9

2,067.3

2,354.7

Capital Expenditure

(160.0)

(172.2)

(141.8)

(149.9)

(174.4)

(203.9)

(207.6)

(209.0)

Capex % of sales

-5.3%

-5.2%

-4.9%

-5.0%

-5.0%

-5.0%

-4.5%

-4.0%

Sale of Property, Plant, and Equipment

-

18.0

151.5

Cash Acquisitions

(19.6)

-

(162.9)

Divestitures

-

-

Invest. in Marketable & Equity Securt.

31.5

1.1

(3.0)

Net (Inc.) Dec. in Loans Originated/Sold

-

-

(24.4)

Other Investing Activities

39.7

(0.5)

(25.4)

Cash from Investing

(108.4)

(153.6)

(206.0)

(149.9)

(174.4)

(203.9)

(207.6)

(209.0)

Total Debt Issued

608.0

-

747.7

Total Debt Repaid

(399.9)

(420.5)

Issuance of Common Stock

619.7

5.8

28.2

Repurchase of Common Stock

(575.3)

(220.4)

Total Dividends Paid

(305.3)

(372.8)

(1,224.3)

(1,005.3)

(1,250.7)

(1,504.9)

(1,714.8)

(1,956.2)

Special Dividend Paid

-

-

Other Financing Activities

(600.6)

2.3

Cash from Financing

(653.4)

(1,005.6)

(448.4)

(1,005.3)

(1,250.7)

(1,504.9)

(1,714.8)

(1,956.2)

Net Change in Cash

594.6

187.1

562.5

106.1

85.8

99.1

145.0

189.6

Discounted Cash Flow

2011

2012

2013E

2014E

2015E

2016E

2017E

Operating Cash

1,346

1,217

1,261

1,511

1,808

2,067

2,355

Capex

(172)

(142)

(150)

(174)

(204)

(208)

(209)

Free Cash Flow

1,174

1,075

1,111

1,336

1,604

1,860

2,146

31,573

Cost of Equity

10.0%

Terminal growth

3.0%

Calculation of Value per Share (in million)

NPV of FCFE for years 2013-2017

4,590

+NPV of Terminal Value

19,604

Equity Value of CME

24,194

Divided by # of shrs o/s at 12/31/2012

332

=Value per share

$73

Source: CME Group: A Monopolistic Toll Booth With Regulatory Tailwinds