Founded in 1898, CME Group (CME - $310.00) was known for over 100 years as the Chicago Mercantile Exchange or the Merc. Its business model has been transaction-based, and is dependent on transaction volume and fees per transaction.
Since converting in 2003 from member-owned privately-held to investor-owned publicly traded, CME has expanded way beyond its roots in agriculture trading. CME has purchased its cross-town rival, the Chicago Board of Trade and the NY Merc, in addition to offering an in-house clearing service. Management recently purchased the Dow Jones Indexes. CME provides the infrastructure for financial transactions and charges a fee for its services, much like an automobile turnpike collector accumulating tolls per vehicle.
The financial sector of the economy is broken down into sub sectors, like regional banks, money managers, and investment banks.
CME falls under the sector of financial exchanges. Companies that provide services to other financial institutions are interesting investments as their fate is based on trading volume and fees rather than lending or underwriting.
Usually barrier to entry is high, but in today’s electronic age, technology needs to be cutting edge. CME has these attributes.
CME provides the physical assets necessary for future and options trading in interest rates, equity indexes, foreign currency exchange, energy products, metals, and its traditional agricultural commodities. CME offers both open-pit and electronic trading platforms. Its clients include professional traders, institutional and individual investors, manufacturers and producers, and foreign governments. The two key matrixes for CME are average daily volume (ADV) of contracts processed and revenue per contract (RPC).
CME will continue to grow by increasing ADV and RPC, along with acquiring businesses and offering new products and services. CME reports volume of trades each month, and Feb 2010 was the highest ADV since Sept 2008 at 12 million trades a day. Year to date, ADV is 19% ahead of last year at 11.9 mil contracts. This strength is centered on improvements in foreign currency, metals, and interest rates. As more clients seek to hedge their investments, or speculate, using futures and options, ADV should continue to grow.
In times of rising interest rates, hedging becomes more important, and CME’s volume increases. With the pending rate tightening in the US and abroad, ADV should continue to show nice gains. This is driving Wall Street estimates higher as revenues appear to be stronger than expected.
About half of CME’s trading volume is directly tied to interest rate (AVD +31% y-t-d) markets. These, however, are lower priced trades and generate about 25% of revenues. Higher volumes in metals (+71%) and foreign exchange (+82%) generate better margins, and these markets have been strong as well. Equity volumes were lower by 14% y-t-d. Higher volumes will translate in to an improving bottom line. Three-month average RPC has increased slightly to $0.852 per contract. Higher trends for RPC and ADV are the basis for increasing EPS and share prices.
CME is a large cap stock with a market cap of $20.6 bil, $2.6 bil in debt and 66 mil shares outstanding. 2009 revenues were $2.6 bil and EPS were $13.29, both down from 2008. CME pays a dividend of $4.60 for a 1.5% yield. With global financial stability recovering, CME is expected to resume its growth in revenue and profits. 2010 revenues and EPS are expected to grow by 15% to $3.0 bil and $15.86, respectively. Looking out to 2012, revenues of $3.5 bil and EPS of $20 are quite possible.
CME recently agreed to form a joint venture to purchase the indexes of the Dow Jones Group. CME will a take 90% stake of a new company that will own the DJIA and 13,000 other proprietary indexes. The deal cost CME $675 mil and generates revenue by licensing its products to other exchanges, such as the CBOE that has the exclusive agreement to trade futures and options on the Dow indexes. CME is also forging a stronger relationship with its Brazilian counterpart, the world’s third largest exchange operator by market cap. BM&FBovespa is anteing up $620 mil to up its stake in CME from 1.8% to 5.0%. CME also recently announced a new strategic relationship with its Mexican counterpart. These recent moves by management indicate they are looking to grow by expanding internationally and by acquiring new products/services.
CME is in the midst of some pretty interesting shifts in financial markets. The government is increasing regulation and oversight on complex financial instruments, such as credit default swaps and derivatives. CME is well positioned to offer solutions of more transparent trading and clearing of CDS contracts, and announced its new service mid-Dec 2009, backed by eight large international banks.
However, competitors are also vying for similar new business, and the politics of financial re-regulation have not yet been totally finalized. A US-based cap and trade system would play right into the strengths of CME and they should be expected to be a factor in trading of carbon credits. Both of these shifts should offer future opportunities for CME to expand its services, revenues and profits.
With 98% of the US interest rate futures market, CME has been periodically faced start-up potential rivals. However, most have fizzled due to lack of profitable volume. In the latest attempt to break CME’s stronghold, NYSE Euronext has announced it is forming a futures exchange to compete with the heart of CME’s business.
Later this month, NYSE Euronext will develop both trading and clearing of Euro future contracts, which represents about 2 mil AVD for CME. The new competitor has lined up some big players as equity investors, such as Morgan Stanley (MS), Goldman Sachs (GS) and UBS (UBS). While CME is currently 4 for 4 in start-up competitor failures, this new challenge may be more formidable, and deserves watching over the next year.
In addition to new potential competitor, CME is facing a legal challenge to its virtual exclusive clearing of its futures contracts. Unlike equities where investors can buy on one exchange and sell on another, CME restricts its futures contracts to be cleared only by its in-house clearing service. An up-start exchange, ELX, is claiming this is anti-competitive and has approached the Commodity Futures Trading Commission (CFTC), the US futures watchdog, on this basis. The issue is being reviewed by CFTC staffers, but the ultimate decision will rest with the CFTC commissioners. If CME were to be forced to allow clearing services by others, it would negatively impact its business and margins. In addition to a potential new competitor, investors should keep abreast of this issue as well.
Investors should have exposure to various sub sectors in the financial industry. CME’s fee for services business model makes it potentially less volatile and more predictable than its traditional banking brethren. Share prices have run from its IPO offer of $45 in 2003 to $700 in Dec 2007. As with most financial equity investments, CME collapsed in 2008 and 2009 to a low in the $170s. Share prices have since rebounded to $350 in Jan, only to shed about 10% to its current price of $310.
While not cheap from a valuation viewpoint, CME could earn upwards of $20 by 2012 and at an 18 to 20 PE should trade between $360 to $400. If share price weaken below $300, it could be an attractive entry point. However, as CME has bounced off the $270 level twice since July 2009, a break below this may signal a new downward leg in share price.
CME should offer long-term investors steady growth in the 12 to 15% range. The strength of CME’s profit margins, cash flow and unique market position has allowed the company to consistently command one of the riches PEs in the business, mostly reserved for high quality money managers. If you are looking to add a well managed large-cap financial services company, CME is well worth your due diligence.
Disclosure: Author holds a long position in CME and has been a shareholder since 2004