IntercontinentalExchange and Chicago Mercantile Exchange Fight for CBOT

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Includes: BOT, CME, ICE
by: Victor Cook

On June 14, 2007, the New York Times DealBook reported the latest development in the Exchange War between the IntercontinentalExchange, Inc. (NYSE:ICE) and the Chicago Mercantile Exchange Holdings (NASDAQ:CME) over a property they both want:

As two of the Chicago Board of Trade’s rivals continue duking it out over the exchange, its board of directors spoke up on Thursday: it favors the Chicago Mercantile Exchange.

But the IntercontinentalExchange seems to want the Chicago Board of Trade (BOT) badly. Dow Jones MarketWatch reported late Tuesday June 12 that the company had enhanced its offer. It now represents a 10.2% premium over Chicago Mercantile Exchange (CME) bid. And,

ICE also said it plans to file a preliminary proxy statement to oppose the proposed acquisition of CBOT Holdings by the Chicago Mercantile Exchange (CME) and solicit votes against the proposed CBOT/CME merger at the CBOT shareholders meeting scheduled for July 9.

Given the reported challenges faced by ICE in shifting CBOT's action to its New York Board of Trade platform, as well as the premium it has already offered to pay for the property, one wonders what's behind this ambitious strategy. CEO Jeffrey Sprecher says "It's a growth play." Is he right?

The Three Parts Of A Dollar

To understand the motives behind an audacious strategic move like Mr. Sprecher's, it's useful to start with the enterprise marketing concept of "the three parts of a dollar." Why? Because it divides the sales dollar up into three mutually exclusive and exhaustive parts that define, with the use of financial accounting data, the company's underlying business model.

3_parts_p01_2

Cost Of Goods Sold

The "cost of goods sold" at the Chicago Board of Trade in 2006 was 0.24%. Does this mean the company's gross margin is over 99%? Yes. Think of these three companies as retailers of risky financial products to highly select clients. Here's how the CBOT defined its business in its 2006 annual report:

CBOT Holdings was formed in April 2005 as a Delaware corporation for the purpose of becoming the holding company of the CBOT which was founded in 1848. Today, the CBOT is the world’s leading marketplace for trading agriculture, grains and U.S. Treasury futures as well as options on futures. In 2006, 13% of the global listed futures and options on futures contracts traded at the CBOT.

It's clear the company does not have a "cost of goods sold" like a product manufacturer or retailer. So what is cost of goods sold at such companies? Simple. The interest paid on borrowed money. The CME was the least efficient with an interest cost of goods sold equal to 8.45%. ICE was the most efficient with a cost of just 0.07%.

Enterprise Marketing Expenses

Calculating the enterprise marketing expenses of these three companies is a little more complicated. And you can't take the SG&A expenses reported in online services. Often the result make no sense. For example, Yahoo! Finance reported that the Chicago Mercantile Exchange had SG&A expenses of +$24.615 million in the 2nd quarter of 2006!

You have several options in assembling enterprise marketing expenses from the income statements of these exchange services. The least attractive option is to comb through each company's annual report and pick out all the line items that fit this definition:

Enterprise marketing expenses are the costs of everyone (and everything) that affects a company's performance in its competition for customers and capital.

If you're interested in the details of which expenses fit this definition see my audio slide show on "Enterprise Marketing Expenses." It runs about 12 minutes.

The most attractive option in my experience is to subscribe to EDGAR Online I*Metrix services:

I-Metrix is a suite of interactive data and analytical tools from EDGAR Online that provides quick and accurate, XBRL-tagged financial statement data via Microsoft Excel and an easy to use web interface or via a direct data feed.

Here's a list of all the line items in the income statements reported by I*Metrix that include at least a single entry for one (or more) of these three companies in their 2006 income statements:

eme_list_p011_3

Each of these enterprise marketing expenses influence the company's performance in competing for customers and capital. Here are the enterprise marketing expenses of each company.

eme_p01_2

There are two big advantages in using I*Metrix to assemble enterprise marketing expenses. First, the line items are standardized across all companies (whether or not they report the expense separately). Second, with a single mouse click you can drill down into the original SEC document to discover which items, if any, were combined.

Could It Be Market Share?

Revenues for the group of three firms totaled just over $2 billion at the end of 2006. The CBOT captured 30.7%, ICE got 15.5%, and CME led the group with 53.8%.

market_shares_2006_p01

Could it be that ICE covets BOT because the combined firms would achieve maximum earnings market share and leapfrog the Merc?

I applied The Rule of Maximum Earnings (this audio slide show runs 12 minutes) to the data for the CBOT.


cbot_max_p01

CBOT's actual operating income was $354 million on a market share of 30.7%. Maximum OIBD of $418 million occurs at 45.5%. How could the Chicago Board of Trade grow that much additional share? If BOT were acquired by ICE their combined market share would be 46.2%! That's only 52 basis points from BOT's maximum earnings share.

Why Leave $100 Million On The Table?

Okay, but what about the alternative? The Merc already owns 53.8% of this market. If it wins the exchange war, the company will own 84.5% of the market. This will maximize its earnings, right? Wrong. This chart shows what happens to market share and earnings if CME wins the bet for the CBOT.

cme_bot_max_p013

If the Merc wins the bidding, combined earnings of the merged companies would be $968 million at a market share of 84.5% on sales revenues of $1,711 million (in red). While maximum earnings of the combined firms are $1,078 million at a 75% market share on revenues of $1,520 million (in green).

Even if the Merc bid doesn't run into anti-trust issues, the market eventually will drive it to downsize to a point closer to its maximum earnings market share. Why? Because the merged companies will leave over $100 million in earnings on the table.

A Big Role For Enterprise Marketing

Where does traditional marketing fit in this seemingly complicated story? Look back at the list of line items from the income statements that contribute to enterprise marketing efforts. The first one is Marketing and Advertising expenses. Only the Chicago Mercantile Exchange reported any of these traditional expenses. And the total was just $16.74 million in 2006. In a strategic group with revenues of $2.0 billion. Traditional marketing's slice of this pie isn't even rounding error.

Does this mean traditional marketing has only a small role to play in financial institutions that serve a relatively small set of highly select customers? Yes, but enterprise marketing can step in and offer CEOs and CFO's unexpected insights into the challenges they face in the competition for customers and capital --- even in esoteric markets. In this case, it appears that the CBOT should think about switching its bet to the ICE before the window closes on July 9, 2007. What do you think?

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