The Chicago Mercantile Exchange (CME) kicks off the month of August reporting season before the bell on Thursday August 1st, 2013, with analyst consensus expecting $0.89 in Earnings per share (EPS) on $803 million in revenues, for flat EPS growth and 1% revenue growth.
CME's stock is up about 50% year-to-date which is quite a surprise given the lack of earnings and revenue acceleration, but I think the stock price appreciation is all about expected higher volumes for Treasuries as the Fed Taper nears, as well as increased activity in euro dollars and credit Default Swaps (CDS).
We've written two articles on CME as a beneficiary of higher interest rates, both here and here, so we won't re-hash the points today, but as Treasury volume improves, and higher volumes are driven over a fixed-cost platform, earnings should get a nice boost.
Two contracts we haven't talked much about in previous writings on CME is euro dollars, and the Credit Default Swap contracts which are still in process of getting up to speed.
Keefe Bruyette & Woods (KBW) noted on a brief research note on FirstCall that CME currently has 21% market share as of mid-July in the CDS market, and is taking share from other exchanges, although volume is still very low.
[As a quick primer on CDS's, CDS contracts were previously traded over-the-counter (OTC) between banks and other financial institutions which meant that any buyer of a CDS had to do counterparty credit analysis on the writer of the swap to insure payment. After 2008 and 2009, and the collapse of AIGFP and Lehman, the regulators have chosen to make CDS contracts available on exchanges, which are then marked-to-market daily, and the Clearing Corporations become buyers to the sellers and vice versa, which will be far better risk management and should provide liquidity to the contracts. I don't think bank counterparties are going away, but the regulators can make the capital requirements (or capital marks) to hold such swaps so onerous, that the writers and buyers would want them on the exchange anyway. As a caveat, I am not an expert on the swap or CDS market by any means, but have gleaned all this from various readings, and research, etc.]
The euro dollars have options associated with them as I understand it, and given that euro's seem to be money-market and fed-funds sensitive any time the Fed would be considering changing its bias or actually even thinking of raising rates, Euro's should attract volume as they did in April - May '13.
Current 2013 and 2014 EPS consensus of $3.25 and $3.74 is leaving CME trading at 23(x) and 20(x) those estimates for expected year-over-year growth of 8% and 1% this year and next.
The 21(x) price to 4-quarter trailing cash-flow is a little scary too. Normally we don't use cash-flow valuations with financials, but the exchanges are a different animal. The exchanges are a fixed-cost business, with substantial operating leverage.
Per one research note out of CreditSuisse, dated July 15th, European and US Derivative Open Interest was up 16% for CME as of mid-July, and the CME saw sharp y/y volume increases in Interest rate, Foreign Exchange, Energy and Metals contracts through the 2nd quarter, 2013.
CME's revenue and estimate revisions have turned positive but I think we would need to see Treasury rates back up further and higher volumes to continue in the key CME contracts such as Treasuries.
To conclude, I do think the Friday, August 2nd, July Payroll Report is critical to the outlook and a potential future catalyst to CME's stock price. The 10-year Treasury Yield at 2.7% is sitting a key level and according to the attached chart, which is the 20+year TLT ETF, the fact that this ETF is sitting right on top of its 50-month moving average is significant. If that support level breaks down, and the 10-year Treasury yield continues to rise, I do think it could drive substantially more volume to the CME's Treasury contract given CME's 99% market share for Treasuries.
If Friday's number is weak and Treasuries rally, the volume could continue to be tepid and the CME won't get the ancillary benefit in euro dollars from a more active Fed.
We like the CME here more so than ICE, although we have owned them both in the past. The biggest contract at ICE is Energy and I think that game has played out.
We await Friday, August 2nd's payroll data and await the technical action within the Treasury market. I do think higher rates are ahead, even of Friday's number is weak, and that benefits CME in a big way.