There is somewhat bad news and very good news. The somewhat bad news is that CME Group (NASDAQ:CME) shares are having a really hard time this year, falling 22% year to date. This doesn't worry me at all as CME's core business couldn't be doing better. So far, every month of this year saw high volatility with volatility in every single area including commodities, currencies, and bonds. It's truly a dream come true for CME. Hence, the (very) good news is that investors get to buy CME Group at a ridiculous price. I have consistently averaged down this year, bringing my current return (minus dividends) to -11%. Given the valuation and CME's super strong business, I bought more.
In this article, I will elaborate on everything I just mentioned and walk you through my thoughts.
So, let's get to it!
There are a lot of reasons why I added CME to my portfolio this year. For starters, CME offers the perfect mix between a high dividend yield and growth. It's a growth/value mix, so to speak.
With a market cap of $64.4 billion, CME is the largest stock exchange operator in the United States as it owns the Chicago Mercantile Exchange (where its name comes from), Chicago Board of Trade ("CBOT"), NYMEX, COMEX, and the Kansas City Board of Trade, among others.
Going back to 2009, the company has returned 16.2% per year, beating the S&P 500 by almost 300 basis points. The same goes for the iShares US Broker-Dealers & Securities Exchange ETF (AIA), which is a good benchmark.
Over the past five years, CME Group returned 12.8% per year, beating the S&P 500 by roughly 100 basis points. During this period, the standard deviation has come down to 21.4%, which is less than 400 basis points higher than the S&P 500. That's a very good number.
What makes CME so powerful is the fact that it has a huge footprint in futures (and related options) trading. If volatility increases, CME benefits.
For example, the company owns the E-mini contract, the biggest equity futures contract in the world (based on the S&P 500). It also owns all major agriculture futures including corn and soybeans. CME also owns gold and silver futures and a wide range of fixed income futures like SOFR and eurodollars. On top of that, it also owns WTI crude oil futures. Brent oil is owned by its peer Intercontinental Exchange (ICE).
Equity and interest revenues account for roughly half of total revenues as the latest 2Q22 data shows. On top of that, the company also sells market data, which I believe will be a segment that we'll talk a lot about in the future as exchange operators are starting to figure out how to monetize data.
Right now, markets are in turmoil. However, markets have been nervous for almost the entire year.
The handy overview below shows the volatility of bonds (the famous MOVE index), currency volatility as tracked by JPMorgan (JPM), and the good old VIX index, tracking equity volatility based on S&P 500 index options.
While 2021 was a rather comfortable year, 2022 is different for all three asset classes.
This week, I wrote an in-depth article on the market's challenges. Essentially, we're dealing with an aggressive Federal Reserve, which is hiking into economic weakness to combat high inflation. This is causing dollars to be drained from "the system", it causes bonds and stocks to fall in lockstep, and it makes everyone extremely nervous.
As bad as all of this is for the market, it's good news for CME Group.
For example, and as reported by Seeking Alpha, these are the year-on-year growth rates - in August - of some of the company's products:
As a result, CME has the huge benefit that it doesn't suffer from a "typical" recession. The company did not suffer during the Great Financial Crisis, nor during the short pandemic recession of 2020. After all, most recessions result in spiking volatility, which benefits CME. The biggest risk is a prolonged recession, which causes market participants to pull back from the market. That's bad for longer-term ADVs.
This year, free cash flow is expected to reach $2.8 billion, followed by a surge to $3.3 billion in 2024. This implies a free cash flow yield of 4.2% using 2022 estimates and 5.1% using 2024 expectations. Keep this in mind for the dividend part of this article.
Moreover, the free cash flow margin (as a percentage of revenues) is constantly rising, which means the company is increasingly efficient. Last year, $0.48 of every revenue dollar turned into free cash flow. Next year, that number is expected to be $0.58. That's very impressive. Especially considering that number was below $0.40 in the first few years after the Great Financial Crisis.
These numbers not only indicate that the company is recession "proof" and increasingly profitable, but it's also great news for its dividends. And that's the reason I'm writing this article.
The CME dividend is a bit different from your "average" dividend growth stock. While the company pays a steadily increasing quarterly dividend, it also distributes almost all of its free cash flow through a special dividend at the start of each year (ex-dividend day in 4Q of the year before).
CME's quarterly dividend is currently $1.00 per share. That's $4.00 per year and 2.2% of the company's stock price. That's a decent yield in itself and backed by a very good-looking dividend scorecard. The company scores high on safety, which is no surprise given the high free cash flow load and the fact that net debt is less than 0.3x EBITDA. That's extremely low.
It also explains why the company has an AA credit rating. That's the same credit rating as the European Union.
This quarterly dividend has grown (on average) by 9.2% per year over the past 10 years. That's impressive and backed by 9.0% annual compounding free cash flow growth in the 2012-2022E period.
These are the most "recent" hikes:
In this case, it's "handy" that free cash flow growth is equal to dividend growth. It means that the dividend is backed by growing fundamentals. However, it also means that we can continue to rely on free cash flow growth to somewhat estimate where the dividend is going.
After all, the special dividend is what really makes a difference here.
The chart below shows the company's regular dividend as well as the special dividend.
The overview below shows what the company's dividend in the past few years looked like. In 2021, the quarterly dividend was $0.90. The special dividend was $3.25. This brought the total to $6.85. That's slightly more than 100% of the company's free cash flow per share of $6.77. That's based on total FCF and 358.2 million fully diluted shares (instead of basic shares outstanding).
These are the expected free cash flow growth rates going forward:
In other words, if these numbers are even remotely right, we're dealing with a stock that is working its way up to a 5% free cash flow yield in 2024 - based on the current valuation. Given the company's dividend policy, this means it's a very high-yielding stock with the growth rates of a dividend growth stock. That's as close to a no-brainer as we can get in my book.
After all, CME doesn't need its cash. It has built a fantastic business model that does not require acquired growth to remain competitive. Also, its balance sheet is so healthy that it would be a "waste" of money to reduce net debt even further.
Moreover, *if* the company were to decide to change its business by investing more in growth (including acquisitions), investors would still enjoy a nice dividend, even if not all of its FCF is distributed.
So, what about the valuation?
I was down roughly 15% on CME Group. I added more at $179.36, to be precise, which is now making CME my 9th-largest position.
To be honest, I did not plan on buying more CME. Yet, I loved the valuation. The yield has become very juicy, and I believe the company will have a blowout year, financially speaking.
So, on top of the highly attractive dividend yield, the company is trading at 18.2x 2023E EBITDA of $3.6 billion. While an 18x multiple may seem like a lot, it's the lowest valuation since early 2018. It is highly common that stocks that spend almost all of their free cash flow on dividends are trading at rather high EV/EBITDA ratios. That's OK as long as the free cash flow margin is high. And that's definitely the case here.
In other words, if we assume that the free cash flow yield rises to more than 4% this year, we're dealing with a very favorable valuation. After all, it's all about getting access to the company's free cash flow at a good price.
Bear markets aren't fun. However, it sure is good to be able to buy great stocks at fantastic valuations. CME Group has become one of my all-time favorite dividend stocks.
The company has a bulletproof business model consisting of the most prominent futures in all categories as well as related services, allowing the company to withstand even severe economic and market turmoil. It also helps that its balance sheet has a better rating than a lot of developed countries.
Even without special events, the company is a cash machine thanks to lower fixed costs and increasing operating efficiencies. The company is now on track to push its free cash flow yield to more than 5% by 2024, which means the long-term FCF growth streak of close to 10% per year is in good shape.
It also means that the company's dividends are secure. The company pays a 2.2% quarterly dividend and a high (expected) special dividend, to distribute almost all of its excess free cash flow.
Moreover, because of ongoing market turmoil, CME is trading at a very attractive valuation, which caused me to buy more.
Needless to say, I am not sure when or where the market is going to bottom. I buy stocks whenever I like the risk/reward, even if that means I have to average down when market-related panic causes people to make irrational decisions.
In other words, regardless of how enthusiastic I am in my articles, always take care of your own risk management. Look for stocks you like and buy when you like the valuation.
If you like a great combination of growth and value, I think CME is the perfect stock for you.
(Dis)agree? Let me know in the comments!
This article was written by
Disclosure: I/we have a beneficial long position in the shares of CME either through stock ownership, options, or other derivatives. 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.
Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.