CME Group (NASDAQ:CME) is the world’s largest derivatives marketplace and specializes in both exchange traded and over-the-counter (OTC) derivatives based on interest rates, equity indexes, foreign exchange, energy, agricultural commodities, metals, weather and real estate. The firm earns revenues in the form of clearing and transaction fees on these products. Interest rates derivatives (20%) and energy derivatives (21%) are the biggest contributors to such transaction based revenues. The firm also provides market data and access services to subscribers for a fee. They also own an index services business in partnership with Dow Jones. that earns licensing fees from the indexes it develops and maintains.
The firm’s current market capitalization is around $19.4 billion, almost equal to our estimate for the same. Its share price has remained in the $50-$60 range for the most part of 2011 and 2012. However, a surge in speculation about exchange consolidation since the beginning of this year has seen the stock’s valuation jump almost 20% from nearly $50 at the end of 2012 to $58.31 as of this writing. We estimate the stock’s fair value to be $58 per share.
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Where is the company’s strategic focus?
The firm, like many other companies in the financial services space, ails from the existing low trading volume environment. The firm is currently focused mainly on diversifying into non-transaction based businesses, building its OTC clearing business and expanding geographically outside the U.S.
Diversification – CME Group recently partnered with Dow Jones and McGraw Hill to create an index services business. They are also expanding their co-location services business, which is likely to benefit from increase in electronic and high frequency trading.
Exploiting regulatory mandate – With centralized OTC clearing set for implementation this year, CME is well positioned to gain from this development. The first set of mandates starts in March and the second phase is scheduled to be effective from June. CME continues to expand its OTC clearing business and the number of clearers on its platform has grown from 10 initially to 23 in February 2013, as reported by the firm’s management.
Globalization – The firm is expanding its OTC clearing services in the U.S. and Europe, and it also looks at Asia as a new growth frontier. The firm is forming alliances with offshore exchanges so that its clients may also be exposed to products outside their local markets. According the company’s management, CME group has a strong pipeline of clearing members coming from Asia.
Why do investors invest in CME?
Cash flows – According to the firm’s management, in 2012, CME returned about $1.2 billion to their shareholders and say they will continue to return cash until they see an opportunity to utilize it elsewhere. High cash flows make the company suited for investors looking for dividend income. They also make the firm a good candidate for a buyout. NASDAQ OMX (NASDAQ:NDAQ) has been reported to be in talks with private equity firms for taking itself private, and although the CME management believes otherwise, we cannot completely rule out the possibility of such a deal in the future.
High margins – CME’s EBIT margin is almost 60% for 2012, according to our estimates. Comparatively, peers like NASDAQ and NYSE Euronext (NYSE:NYX) have EBIT margins of 21% and 22% respectively. With most of the costs fixed and a higher margin compared to its peers, CME is likely to see a significant upside to its stock price should trading volumes improve in the future.
What are the major threats?
Trading volumes – A large part of CME group’s revenues come from transaction based revenues, and is hence, susceptible to a variation in trading activity. Although January witnessed an uptick in trading activity, the macro-economic environment is still uncertain. If volumes recede back to lower levels of 2012 – either due to a prolonged recession in Europe, US sequestration or any other shock – the firm is likely to take a significant hit to its top line numbers.
Intense competition – CME is well positioned to take advantage of the changing regulatory environment and continues to expand its clearing operations. However, it is likely to face intense competition from IntercontinentalExchange (NYSE:ICE), should ICE be successful in acquiring NYSE Euronext. NYSE Euronext’s LIFFE business complements ICE’s product portfolio and will give them the same breadth of offerings that CME enjoys currently.