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Volatility in the global financial markets is at unprecedented levels. 2011 saw record volatility, including 4 consecutive 400 point swings in the Dow Jones Industrial Average (DIA). The financial crisis has turned the markets into what seems like a permanent position of trading the headlines and asking questions later. And a prime beneficiary of that volatility is CME Group (CME).

CME Group is a holding company that controls the world's largest futures exchanges. The company controls the NYMEX, COMEX, CBOT, and CME exchanges, which allow investors access to a wide variety of futures and derivative products, including energy, metals, FX, equity markets, weather, and interest rates. The company was formed in 2007 from the merger of the Chicago Mercantile Exchange and the Chicago Board of Trade, and in 2008 it acquired the NYMEX and COMEX exchanges. Year-to-date, CME has outperformed the S&P 500 (SPY), with shares up nearly 19% as of this writing, compared to the market's 12% advance.


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Background

It should be noted that we are not fans of the financial sector as a whole. Aside from a few recommendations [buy American Express (AXP) as a play on luxury spending, Morgan Stanley (MS) due to hysteria in Europe, or Citigroup as a play on emerging markets (C)], we have largely avoided recommending financial companies on Seeking Alpha. That is not due to a bearish view on the financial sector per se. Rather, we simply don't invest in financial companies because we believe that there are much better non-cyclical companies to invest in. Our investment philosophy is based on investing not in sectors, but trends. A spectrum crunch and LTE network buildout in the United States? Enter Qualcomm (QCOM) and Clearwire (CLWR). A boom in biotech M&A? Enter Alexion (ALXN), Achillion (ACHN), and Idenix (IDIX). These are all secular trends that transcend the vagaries of the business cycle. Financials however, are wholly linked to the business cycle. And other than occasional bouts of financial engineering (which has had very mixed results; how could anyone possibly think that synthetic CDO's are a good idea?), the financial sector is one that has precious little to produce in the way of clear, secular trends.

CME: The Difference is in Derivatives

CME, however, is a different kind of financial company, one with clear secular trends serving to benefit it When the world faces financial risk, CME is the company that benefits. CME is not a traditional exchange. It focuses on macroeconomic derivatives (FX, interest rates, indexes, commodities, etc. …), and therefore record volatility is leading to record revenues and profits for CME as its customers utilize it more and more to hedge their risks and try to stay a step of the head of unprecedented swings in the world's financial markets, as well as the wholly unconventional policy responses to recent macroeconomic events.

CME has built a great business model with outstanding margins and cash flows. The business is not very capital intensive, allowing for aggressive returns of capital to shareholders. CME boosted its dividend 59% when it reported its first quarter results and announced a special dividend of $3 per share. And that dividend was not a one-off event. From now on, CME will consider a special dividend during the first quarter of every fiscal year. Companies do not raise their dividends by such levels if they are not confident in the future. And by any measure, the future should be good. The kind of volatility we have seen in 2010 and 2011 will most likely become the new normal, as markets react to headlines first and ask questions later. CFO James Parisi favors dividends over buybacks, arguing that they deliver predictability to investors compared to the sporadic nature of buybacks (insert endless arguments over the value of dividends vs. buybacks). We provide an overview of CME's financials below.

Financial Overview, 2008-2011*

2008A

2009A

2010A

2011A

2012E

2013E

Revenue

$2.561019 Billion

$2.6128 Billion

$3.0037 Billion

$3.2806 Billion

$3.3 Billion

$3.6 Billion

Expenses

$978.824 Million

$1.0237 Billion

$1.1726 Billion

$1.2595 Billion

N/A

N/A

Operating Income

$1.582195 Billion

$1.5891 Billion

$1.8311 Billion

$2.0211 Billion

N/A

N/A

Operating Margin

61.78%

60.82%

60.96%

61.61%

N/A

N/A

Net Income

$715.486 Million

$825.8 Million

$951.4 Million

$1.8123 Billion**

N/A

N/A

Profit Margin

27.94%

31.61%

31.67%

55.24%

N/A

N/A

EPS

$12.13

$12.31

$14.31

$27.15**

$17.83

$20.34

Operating Cash Flow

$1.1972 Billion

$1.0831 Billion

$1.3564 Billion

$1.3463 Billion

N/A

N/A

*Data prior to 2008 reflects the legacy CME business

**EPS and net income for fiscal 2011 include a one-time tax benefit related to state tax apportionment and changes in deferred tax liabilities (total tax benefit taken in the fourth quarter is $377 million, or about $5.69 per share). Tax provisions for fiscal 2011 fell by $647.7 million from fiscal 2010 (about $9.70 per share)

The financial crisis did little to negatively impact CME's business, as it is exactly the kind of environment the company thrives in. Each of the past 4 years has brought new records in revenues and operating income, as volatility and increased market risks drive people to hedge themselves with CME's products.

MF Global & Corporate Leadership

The 2 main risks we have identified with the company are continued fallout from the bankruptcy of MF Global, as well as the company's board structure. We will address the board structure first, for it is the "simpler" of the 2 risks facing CME.

Because CME was formed from the 2007 merger of the legacy CME and the CBOT, and then became what it is today with the purchases of NYMEX and COMEX, its board of directors reflects those acquisitions. What makes the board stand out is its size. The average corporate board has 8.3 directors. Not CME's. It has 32. CME likely has the largest board of directors of any public company. If a small board can be harmful due to a lack of breadth, than a large board can be harmful due to a lack of oversight. Even though CME has nearly 4 times as many directors as the average company, it is unlikely that its board meetings are 4 times longer. Thus, it can be argued that each individual director is less engaged in the business. CME has such a large board of directors due to the shareholder structure of the company, as well as the terms of its merger agreements. Class B shareholders, along with 3 separate groups, choose 6 directors, and the rest are elected together by Class A and Class B shareholders (Class A shares are publicly traded). And until this year, CME has been required to appoint 10 directors to represent CBOT interests. Furthermore, it costs CME over $5 million per year to maintain such a large board. When total company expenses are not even $1.5 billion, this figure means more than it would at other companies with larger cost bases (this expense works out to about 8 cents per share). CME, however, is working to rectify this issue. The board will shrink to 30 directors this year, and by 2014 it will convert to electing its board annually, which will make it even smaller. Furthermore, we have not seen any analyst or market movers criticize CME for the size of its board, nor have we seen an analyst refuse to recommend CME's stock based on the size of its board.

We turn now to MF Global, whose bankruptcy is the biggest risk to CME, even though MF Global filed for bankruptcy on October 31. What distinguishes the MF Global bankruptcy is that it appears the company used segregated customer funds to fund its own operations, something that violates the sacred rule of futures and derivatives trading: customer funds must always be accessible to the customer. As the nation's leading futures exchange, CME was the front-line regulator of MF Global, and it can be argued that CME should have seen this and prevented it from ever happening in the first place. The MF Global bankruptcy also affected CME's trading volumes, though they are moving back to normal levels (the bankruptcy of one of CME's member broker-dealers is the greatest operational risk to its business).

As with its board issues, CME is being proactive. While it is highly likely that we will never know just exactly who knew what and when, it is possible that CME was deceived by MF Global. Either way, CME should have done better. In the days after MF Global's bankruptcy, CME had poor communication with customers and was slow to respond to developments (The latest plan is to distribute $685 million to customers, though it is mired in controversy). CME is responding to the MG Global bankruptcy by launching a $100 million fund to provide additional protection for the segregated funds of farmers and ranchers who utilize CME's exchanges (from a PR standpoint, the biggest impact of MF Global's bankruptcy was on its agricultural customers). Customers will be eligible for up to $25,000 in protection in the event a member of the CME becomes insolvent, and cooperatives are eligible for up to $100,000 in protection. In response, S&P cut CME's credit rating to AA- from AA, citing potential costs related to this safety net. In addition, S&P is concerned that CME may have a difficult time extending its reach into the CDS market in the future. It should be noted that an AA credit rating is still very strong, with only 21 companies in the S&P 500 having a rating of AA- or higher. CME shares jumped 6% when it announced the creation of the fund alongside its fourth quarter and 2011 results.

CME is also undergoing a leadership transition. CEO Craig Donohue is stepping down at the end of 2012, and will be replaced by President Phupinder Gill. Executive Chairman Terrence Duffy will assume the role of President. Inevitably, speculation has swirled that Donohue's retirement is related to CME's handling of the MF Global bankruptcy, for it has tarnished his legacy as CEO. The official CME line is that Donohue has been considering this "for quite some time." Sources close to the company confirmed to the Wall Street Journal that Donohue has begun thinking about leaving around 7 to 8 months ago. His replacement, Phupinder Gill is seen as a capable executive. He was key in securing the votes needed to approve the CBOT deal that created the new CME, and represents the company on the boards of several foreign exchanges, including those of Mexico and Malaysia. Richard Repetto of Sander O'Neil summed up the transition thusly: "The transition from Mr. Donohue to Mr. Gill means the CME will be going from the very articulate, polished executive to the operational guy who got things done."

The Road Ahead

Market volatility is here to stay. And CME will be a prime beneficiary. 2012 is set to be another record year for CME in terms of revenue and operating income. And as the economy recovers and Treasury yields rise, uncertainty over interest rates will benefit CME, according to KBW. CME is also working steadily to expand its international presence. Its collaborations with a myriad of exchanges all across the world allow its customers to have unparalleled access to the global derivatives market. Most recently, CME announced a cross-licensing agreement with BOVESPA. CME will also continue to reward shareholders with increased dividends, and as it pays down debt, more and more cash will become available for dividends.

Balance Sheet, Valuation, and Market Consensus

CME ended 2011 with $1.0899 billion in cash & investments, and $2.1068 billion in debt. CME retired over $420 million of debt in 2011, and we expect continued deleveraging in 2012. Operating cash flow will be strong in 2012, allowing for the company to both invest in the business and strengthen the balance sheet.


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CME trades at an unassuming valuation. Its trailing P/E is 10.64, and its forward P/E ratio is 16.23, though it should be noted that its trailing P/E is distorted by the tax benefits the company received in 2011. While we do not believe that an analysis of the company should hinge solely on valuation (lets buy this because its cheap or lets avoid it simply because it is expensive), we do think that CME's unassuming valuation is a positive. And so is its stock price. CME has been a victim of the financial crisis because of its perception as a financial company. Its stock price peaked on December 21, 2007 at $710.75. It closed on March 30, 2012 at $289.33. And yet, revenues and profits grew steadily in those years, and the dividend grew from 86 cents per share to $2.23, for a current yield of 3.08%.

The Reuters average price target for CME currently stands at $302.18, representing upside of just 4.44%. However, the average is slowly trending up, and recent analyst moves have been positive. UBS recently raised its price target from $311 to $330 (14.06% upside), citing the fact that rising interest rates and a corresponding rise in volatility and the use of hedging will be a positive for CME. The company is UBS' favorite play on rising interests in the exchange space. If rates rise alongside an economic recovery, CME wins because there is a need for more hedging. If rates rise due to budgetary worries, CME wins because rates still rise. And if rates fall because of worries over the economy, Europe, etc. … the schizophrenic nature of the markers will cause CME to win due to a rise in volatility.

Conclusions

CME Group is a different kind of financial company. The same volatility that sparks fear in other financial companies is welcomed at CME. CME is addressing the issues surrounding MF Global, and is slowly but surely working to strengthen its corporate governance. The company is steadily raising its dividend payouts, and should have even more cash to deploy in the years to come as debt is repaid and cash flows grow. Is CME a financial company? Yes it is. And is it poised to do well regardless of the state of the global economy? All indicators say yes it will.

Source: Consider CME Group: It Is A Different Kind Of Financial Company