During the gold rush its a good time to be in the pick and shovel business." - Mark Twain
We start off with the Mark Twain quote because the idea is to find businesses in a booming industry that makes money no matter what happens. If the gold digging 49er strikes it rich, you win. If he doesn't, you still win. If the macroeconomics of the industry is strong, the business is profitable. I have heard the CEO of one such "shovel maker" state:
We want to get in the way of the growth.
As other businesses attempt to strike it rich, you want your business to be there to support their endeavors. The winners in the gold rush will buy more of your products (or services) and the losers will fall off. As long as the industry as a whole is growing, the winner's growth will outpace the loser's downfall.
The Real Winner of the Gold Rush
CBOE is the Shovel Maker of Finance
CBOE Holdings (NASDAQ:CBOE), operates the market where investors and speculators come together to invest in various derivative contracts. They are the platform where literally trillions of dollars are traded each year. CBOE does not engage in trading per say. They are just the intermediary and facilitate trades between others. This means there is very little risk for a company like CBOE. It is the classic "heads I win, tails you lose" situation.
Another beautiful part of the business is that their services are needed in any type of market. In a hot market, investors are lining up to buy options to lever their returns. In a down market, investors are lining up to profit on the downturn. In a sideways market, investors can profit from no movement. It's a win win win.
On the flip side, their market attracts those that wish to protect their capital through various hedging strategies. It's fun for all ages!
How Does CBOE Make Money?
CBOE generates a majority of its money through transaction fees. 76% of their revenue is based on their exclusive license agreements regarding S&P 500 Index options (42%) and volatility based options and futures (36%) (source: Valueline). In English, they get a cut of every trade that happens on these products without the risk. For the numbers, I'll be using the OSV Stock Analyzer.
CBOE has only been public since 2009 so that's why the numbers are from 2009 onwards. Take a look at these fantastic numbers from the income statement.
Some key points include:
- Revenues are steadily growing every year
- The margins are huge and steady
- Net income is steadily growing YOY as well
Since CBOE is a platform, there are no COGS. This is a fixed cost business. The platform is built and since it is almost entirely electronic, it is easily scalable. Any growth in revenue easily falls to the bottom line. There is very little that needs to be done to get that next sale.
On the Balance Sheet, we see more great things.
With a market cap of $4.35B, CBOE has very few assets on the books to back it up. This would be a concern, but their true assets are not counted. The real asset CBOE holds is the network.
The Real Economic Moat of CBOE
Institutions are plugged in and there is a very large switching cost for customers. Coming off their network is both expensive for the physical changes AND in execution. Leaving the CBOE means not being able to play in that market. This could lead to lost opportunities. CBOE's customers need to have access to execute their strategies.
Think of this asset like Facebook. Facebook's network is valuable because everyone uses it. CBOE is valuable because traders are on it. For one to break away, it hurts them and has little impact on the network. Thus, everyone has an incentive to stay.
Unlike Facebook, the customers actually need to be on the network to put food on the table. This is a huge economic moat. For a competitor to come in, they would have to build an identical network and provide the same optionality that CBOE provides for less.
I liken it to a startup competing with Visa, MasterCard and AMEX. In addition, they have no debt. After all, there is not much to buy once the network is complete. All the profits are there for the shareholders. I love this.
Cash is Gushing Out
The Cash Flow Statement tells a similar story:
All of CBOE's activities are financed organically. Cash Flow from Operations has doubled in 5 years. CAPEX is only around $30M/year for the last 5 years and there is very little new investment that needs to be made compared to what it brings in. This translates into a shareholder win in the Cash Flow from Financing Activities.
CBOE is steadily buying back the shares it issued when it went public. This is on top of a dividend. They are rewarding shareholders and as a shareholder, I like being rewarded.
Key Points, Fair Value and Conclusion
CBOE has a huge moat around its business. The derivative market is only going to get bigger. Derivatives are a Pandora's Box. Once it opens, you can't put it back in. This means long term steady growth.
The fundamentals are strong:
- Revenue growth that translates directly to the bottom line and into cash
- A rock solid Balance Sheet with no debts
- Very little CapEx
- Cash Flow that is being spent on shareholders
I am using a very low discount rate on this one, given the stability of the fundamentals. I see fair value at just over $80. This is a long-term play. I do not see CBOE as a short-term trade, but as a core long-term holding that will slowly, but steadily appreciate.
Disclosure: Author is long CBOE.