CME Group Cashing In On Globalization

| About: CME Group (CME)

Summary

CME Group offers a wide range of global benchmark products (derivatives) across all major asset classes.

CME is seeing its investments in globalization pay off. Electronic average daily volumes in Europe and Asia have grown steadily from 2012.

Though the company's long-term demand drivers appear to be stable, the same cannot be said for its annual dividend.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

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By The Valuentum Team

Security and commodity trading firm CME Group (NASDAQ:CME) is seeing its investments in globalization pay off. Electronic average daily volumes in Europe and Asia have grown steadily from 2012 with no sign of slowing any time soon. Long-term growth trends in a variety of its environments are not expected to let up. Pro forma average daily volume has advanced at a 14% CAGR from 1972 to 2015. Some may be anticipating a plateauing of the pace of globalization, but the continued development of financial systems in emerging markets bodes well for CME Group.

Though CME Group's long-term demand drivers appear to be stable, the same cannot be said for its annual dividend. In 2012, the firm introduced a variable dividend policy, and since then, it has returned more than $6 billion to shareholders in dividends. The dividend yield over the last four years was over 5%, but such a lofty yield cannot be guaranteed in the future (as price will always be a consideration). CME Group has kept a minimum of $700 million in cash on its balance sheet, but the company's variable dividend policy creates the opportunity to return excess cash to shareholders at the end of each year based on operating results, potential investment activity, and other forms of capital return.

Income investors looking for high levels of dividend dependability on a yearly basis may want to explore other options. Now let's dig into the remainder of CME Group's investment thesis:

CME Group's Investment Considerations

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Investment Highlights

• CME Group offers a wide range of global benchmark products (derivatives) across all major asset classes based on interest rates, equity indexes, foreign exchange, energy, agricultural commodities, metals, weather and real estate. CME traces its roots back to the 19th century and is based in Chicago.

• Electronic trading value accounts for ~80% of its business, and the firm generates the most clearing and transaction fee revenue from its interest rate (~25% of sales) and energy (~20%) product lines.

• The company's two main competitive strengths include providing highly liquid markets and offering the most diverse product line. Customers prefer CME's centralized market primarily because of its liquidity and price transparency. The firm's products offer a means for hedging, speculation and asset allocation.

• CME's business has a high degree of operating leverage, which was on full display in the first quarter of 2016 as its incremental operating margin was an impressive 90%.

Business Quality

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Economic Profit Analysis

In our view, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.

The gap or difference between ROIC and WACC is called the firm's economic profit spread. CME Group's three-year historical return on invested capital (without goodwill) is 39.2%, which is above the estimate of its cost of capital of 10.4%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.

In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

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Image source: Valuentum

Cash Flow Analysis

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Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. CME Group's free cash flow margin has averaged about 39.5% during the past three years. As such, we think the firm's cash flow generation is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At CME Group, cash flow from operations increased about 18% from levels registered two years ago while capital expenditures fell about 9% over the same time period.

Valuation Analysis

We think CME Group is worth $104 per share with a fair value range of $83-125.

The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 7.5% during the next five years, a pace that is higher than the firm's three-year historical compound annual growth rate of 4.5%.

Our model reflects a five-year projected average operating margin of 68.6%, which is above CME Group's trailing three-year average. Beyond Year 5, we assume free cash flow will grow at an annual rate of 5.7% for the next 15 years and 3% in perpetuity. For CME Group, we use a 10.4% weighted average cost of capital to discount future free cash flows.

Image source: Valuentum

Image source: Valuentum

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Image source: Valuentum

Margin of Safety Analysis

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Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $104 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for CME Group. We think the firm is attractive below $83 per share (the green line), but quite expensive above $125 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

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We estimate CME Group's fair value at this point in time to be about $104 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of CME Group's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $133 per share in Year 3 represents our existing fair value per share of $104 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.