- CBOE's stock has been lackluster over the last year.
- The current environment with heightened trading and volatility is good for the company.
- It is effectively allocating capital to growth acquisitions, dividend and share buybacks.
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Cboe Global Markets (BATS:CBOE) operates the largest options exchange and the third largest stock exchange in the US. In addition, it operates a stock exchange in Europe. The stock's performance has been lackluster over the last year, but I believe it is now well-positioned to outperform.
The company has a 1.5% dividend yield while you wait. If the company executes well, I believe the stock can rise to $125 for more than 25% upside from the current $98 level.
The company is headquartered in Chicago and has five business segments:
Options: This includes index options that are exclusive to the company, as well as non-exclusive equity and ETF options. 39% of revenue in the last quarter reported.
US Equities: Listed equities and transaction services on the company's exchanges. 51% of revenue.
Futures: Primarily VIX futures. 4% of revenue.
European Equities: Listed European equities transaction services. 4% of revenue.
Global FX: Foreign exchange trading services on the company's platform. 2% of revenue.
The company's sources of revenue are as follows:
Transaction fees: This fee is based on trade volume with tiered discounts for executing trades on its markets. 72% of revenue in the last quarter reported.
Access and capacity fees: These are fees for trading-related functionality, terminals, trading floor space and telecom services. 6% of revenue.
Market data fees: This covers the charge for proprietary and other market data. 6% of revenue.
Regulatory fees: This is primarily the option regulatory fee which supports the company's regulatory oversight function. In addition, the company collects fees on behalf of the SEC. 15% of revenue.
Other revenue: Primarily licensing revenue and from ads on the company's websites. 1% of revenue.
The company's operations continue mostly as normal in the COVID-19 age. Notably, it has benefited from increased trading volume in equities and options.
Financial overview and outlook
In the three months ending March 31. 2020, revenue less cost of revenues was $358 million (up 28% YoY) and operating income was $226 million. Net income of $157 million spread out over 110.6 million shares resulted in diluted EPS of $1.42, up from $0.85 in the prior year. The company's declared pro-forma EPS was a little higher at $1.65 as it excludes amortization of acquired intangible assets.
The company has $165 million of cash and $868 million of debt. Its market cap is $10.8 billion and Enterprise Value is $11.5 billion.
The company generated $163 million of cash in the quarter, which it returned to shareholders in the form of $40 million in dividends and $120 million to repurchase stock. In addition, it depleted its cash balance by spending $11 million on capex and $62 million on acquisitions.
While trading volumes have declined from the surge in March, they still remain healthy. The company is expected to generate $1.25 billion in net revenue this year, up 10% over the prior year. Earnings are expected to climb 10% as well and the company is expected to earn $5.23 per share this year.
Valuation: Fair value of $125 for the stock
I will conservatively use $5 per share as an earnings figure for the company. The stock was trading at a 25x multiple pre-pandemic, and since then market multiples have increased as interest rates have come down along with earnings estimates for most companies. I believe 25x is an appropriate multiple for the stock, which would translate to fair value of $125 per share. Thus, the stock offers more than 25% upside from the current $98 price.
In a bull case, the company will increase its earnings more than expected and generate $5.60 of EPS. Using the same methodology as above, this would translate to a $140 target price or more than 40% upside.
In a bear case, the company's revenue and operating income will decline and the company will miss estimates, generating only $4.40 of EPS. Disappointed investors will assign an 18x multiple, resulting in a $79 stock price for 20% downside.
The company is one of the few that is still actively buying back stock. A few days ago, it announced an additional $250 million repurchase authorization.
The company is under-levered, with interest expense amounting to only 3% of its operating income in the latest quarter. I believe the company can comfortably support another $3 billion of debt, which could enable it to buy back a quarter of its shares at the current price. This would be more than 15% accretive to EPS if the debt is raised at a 4% rate.
Risks are moderate
The biggest risk here is that the company's earnings will come in lower than expected due to macroeconomic, competitive, or execution factors.
A rapid increase in interest rates could prompt equity investors to pay lower multiples. I believe that interest rates are unlikely to increase a lot with a weak economy and a dovish Federal Reserve.
There is a possibility that due to extreme volatility or fraud one of the company's members will default on its obligations, making the exchange liable for trading losses.
Like other enterprises, the company runs the risk of a crippling cyber-attack.
The company actively makes acquisitions and there is a risk that it will make an overpriced one that is material.
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Analyst’s Disclosure: I am/we are long CBOE. 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.
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