The Chicago Mercantile Exchange (CME), a stalwart of the 2003 - 2007 bull market that traded from under $50 to $700 in that time period, reports 2nd quarter earnings before the bell on Thursday, July 26th, with analyst consensus expecting $0.82 in earnings per share (EPS) on $796 million in revenues for expected year-over-year declines of 7% and 5% respectively.
CME recently split its stock 5-to-1, giving investors a chance to own a premier clearing exchange at a lower dollar value than its prior $250 per share trading price.
Within the futures pits, the last 10 years has seen a huge transition from open outcry to electronic trading as now more than 80% of trading volume executed on CME is electronic. This is good and bad in our opinion. High Frequency Traders (HFT)s can abuse this privilege and the growth in electronic has sent the floor traders upstairs to the trading screens, but it has lowered execution costs for investors. Is there a place for open outcry -- we think so -- but the fact is electronic trading is here to stay, however we think a balance will be eventually found between the two systems.
We think the biggest catalyst to CME will be when interest rates start to return to normalized levels, a contract on the CME which represents about 40% of average daily volume.
Volume and price are the key metrics for CME, and given the state of the capital markets and the economic slowdown, volume and open interest have been slowly declining at the CME.
In 2012, analyst consensus is expecting $3.27 in eps, down 4% from 2011's $3.41. Revenue growth in 2012 is expected to decline by the same amount. At 15(x) this year's earnings, and about 11(x) cash-flow, CME isn't screamingly cheap, but it is more appealing than a lot of names out there. One analyst (Bank of Montreal) note at the end of the first quarter detailed that CME will have $1.6 billion in excess cash by the end of 2012, and will distribute $700 million to CME shareholders, which calculates to (pre-split) about $10 per share to current stockholders.
We won't try and predict what or how CME will trade after earnings on Thursday morning, but we do think the CME has the right model going forward. The regulatory movements since the '08 - '09 financial meltdown has indicated that marking-to-market and having airtight collateral behind the over-the-counter credit-default-swap market would have prevented (or at least limited) the degree and magnitude of the crisis in 2008. My own opinion (which could be wrong) is that standardizing many of these current over-the-counter (OTC) contracts on an exchange would increase transparency and flag problems before they get to the crisis stage. While that is simple in concept, it does require liquidity, and sometimes it takes a while for markets and contracts to develop.
2008 - 2009 and the near collapse of capitalism was all about transparency and risk management, and the regulators and mechanisms failed badly. The exchanges are a risk management venue and monitor positions daily, and the exchanges and CME represent the best early-warning and risk-management vehicle. Especially with CME having a broad product offering of contracts:
1.) interest rates (approximately 40% of q2 '12 volume),
2.) equities (approximately 23% of q2 '12 volume),
3.) energy (14% of q2 '12 volume approximately),
4.) commodities, 10% of q2 '12 vol. approximately),
5.) metals and forex being the remainder;
CME's model is all about volume and operating leverage. Driving more volume over that fixed-structure that is a modern-day exchange, drives margins higher and grows earnings per share. It may take some time for the volumes to return to all of the US markets, given the state of Europe/China and the US political morass, but CME's much improved dividend yield and cash-flow give an investor reason to wait.
A trade over $54 on volume for CME will take the stock back above its 50 and 200 day moving averages. We likely won't buy ahead of the earnings report on Thursday, but this is one stock that could trade better than a lot of financials as volume returns to the capital markets.