CME - CME Group: My Favorite Financial Dividend Stock

2023-10-08 06:14:21 ET

Summary

• CME Group stands out as a resilient financial dividend stock, capitalizing on market volatility and avoiding credit risks faced by many regional banks.
• CME Group's extensive range of derivatives, diverse exchanges, and role as a primary price discovery provider makes it a standout asset-light business with high barriers to entry.
• With a robust dividend history, consistent growth, and a favorable valuation, CME Group presents a compelling opportunity for long-term investors seeking strong dividend yields in a volatile market.

Introduction

I feel whenever I say that something is my favorite , it comes with a whiff of clickbait. However, I'm very serious (I always am). CME Group ( CME ) is my favorite financial dividend stock. Not just at the moment, but it has been for a while.

On July 27, I wrote an article titled Dividend Investors Take Note - CME Group Is Back . In that article, I discussed an increasingly favorable market environment for the stock. Especially after a very volatile sideways trend since 2019, the stock is now finally sowing upside momentum, rising 26% year-to-date.

In light of new market developments, I'm dedicating this article to explaining why I am convinced that CME Group is one of the most resilient financial dividend (growth) stocks on the market.

Not only does the company avoid default and related credit risks that some regional banks are struggling with, but it is actively benefiting from the return of volatility in almost every single asset class.

As I'm deciding how to structure my portfolio for the next few years, I've decided that I'll be buying a lot more CME stock than I initially planned.

In this article, I'll walk you through my thoughts.

So, let's get to it!

A Challenging Macro Environment

We may be in the most challenging market environment since the Great Financial Crisis. In this case, I'm excluding the uncertainty in 2020 when the world was figuring out how deadly the new COVID-19 virus may become. That was a scary time but not necessarily as economically complex as the current situation.

We are currently facing a combination of challenges, such as a decrease in economic growth. Several European countries are already experiencing a recession, China's economic growth is expected to stall due to significant problems in its housing market, and in the United States, growth indicators suggest weaker demand.

On top of that, inflation remains sticky. This is an even bigger issue now, as 80% of American households have run out of savings. This is one of the reasons why so many consumer-focused stocks are performing so poorly.

Sticky inflation is also causing interest rates to remain elevated, which is hurting credit quality and economic demand. Homebuyers now have to give up an average of 35% of their income to get a loan. That's up from the historical average of 28%.

As a result, we're seeing an upswing in delinquency rates in auto loans, credit cards, and even mortgages.

Also, to make things worse, we're about to see a wall of debt maturities over the next few years. This includes private and public debt.

Current expectations are that the federal government is on pace to spend $1.0 trillion on interest payments by 2029. In 2020, that number was close to $300 billion.

At this point, the question is whether the Fed gets lucky and inflation quickly falls again in order for the bank to gradually lower rates or if it needs to act so aggressively that it hurts the economy to reach its inflation target.

Looking at the market, I believe we're moving toward a hard landing.

Having said all of this, my strategy remains unchanged. I buy high-quality companies at great valuations. This lets me sleep well, even if it means my net financial worth is on a roller coaster.

One of the best stocks to hold in this environment is CME Group.

What Makes CME Group So Powerful

CME Group operates in the financial sector. However, it's very different from banks and most financial institutions.

This company is a powerhouse and the owner of so many derivates and exchanges that are used every single day. Buying CME is a bit like owning a casino. It's better to own the house than to try your luck in the casino.

In the case of CME, the company with a market cap close to $80 billion owns a number of major exchanges.

• CME (Chicago Mercantile Exchange):

CME offers a wide range of futures and options contracts, including interest rate products (e.g., Eurodollar futures and options, Treasury futures), equity index products (e.g., E-mini S&P 500 futures, Nasdaq-100 futures), foreign exchange products (e.g., currency futures), agricultural commodities, and more.

• CBOT (Chicago Board of Trade):

CBOT trades various futures and options contracts, including agricultural products (e.g., corn, soybeans, wheat), interest rate products (e.g., U.S. Treasury futures), and equity index products (e.g., Dow Jones Industrial Average futures).

• NYMEX (New York Mercantile Exchange):

NYMEX specializes in energy and metals products, trading contracts for crude oil, natural gas, heating oil, gasoline, and metals like gold, silver, copper, and other base metals. This includes the WTI crude oil contract.

• COMEX (Commodity Exchange, Inc.):

COMEX focuses on metal products, including contracts for gold, silver, copper, and other base metals.

Looking at its 2Q23 overview, we see that the company makes a big chunk of its money from interest rate and equity index derivates. This includes the S&P 500 E-Mini and an almost endless range of tools to hedge (and trade) interest rate fluctuations.

Besides its unique range of derivatives, what sets CME Group apart is its role as a primary price discovery provider, offering crucial referential pricing information through real-time, historical, and derived data formats.

This facilitates customers in both listed and cash products. Moreover, they provide industry-leading research and analytics tools, serving as valuable market education resources.

The company helps corporate treasuries to hedge interest rate risks, farmers to hedge crop price risks, food producers to hedge inflation risks, gold miners to hedge against falling metal prices, and so much more.

What makes this wide-moat business so powerful isn't just the high barriers to enter and its massive footprint but also that it's an asset-light business model that does not require extensive investments to expand products and services.

CME's innovation is mainly focused on new services and derivates. So far this year, the company has announced a number of new derivatives that cater to new needs to hedge risks. It also allows market participants to track prices and speculate on price changes.

• CME is about to roll out new micro Henry Hub futures and options for energy investors.
• The company will launch cobalt hydroxide futures for the ongoing energy transition and changing metal needs.
• The company is launching new micro gold futures for rising demand from smaller-scale traders.

All of these headlines can be found on Seeking Alpha , among many others, as CME is rapidly expanding its product portfolio.

Another major aspect is that CME has a somewhat anti-cyclical business. After all, when markets become volatile during (or prior to) recessions, the company makes more money.

Looking at the chart below, we see two major things:

• During recessions, the company sees higher revenues (and earnings + free cash flow). This also goes for non-recessionary periods of turmoil like the 2015 manufacturing/commodity recession and the 2011 debt crisis. It also goes for the current environment.
• The company's free cash flow often exceeds net income, which is a sign of high-quality earnings.

This brings me to the dividend.

The CME Dividend

Because of its mature business model, the company has no need to build a large cash position. Unless it wants to engage in major M&A. However, for now, there's no indication that the company is looking for major deals.

As a result, CME has made the decision to pay almost every penny in free cash flow to shareholders!

This is what its dividend history looks like:

On top of consistent base dividend growth, the company pays an annual special dividend.

The current base dividend is $1.10 per share per quarter. This translates to a yield of 2.1%.

On top of that, the company announced a $4.50 special dividend in December 2022 (it usually announces these special dividends in December). If we assume that we get a similar dividend this year, the total dividend yield is 4.2%.

Total dividends paid last year were $2.8 billion. Total free cash flow was $3.0 billion. This year, free cash flow is expected to be $3.4 billion, which translates to an FCF yield of 4.5%.

In other words, that's what the total yield this year could look like.

I think it could be higher, as we're seeing elevated volatility in every asset class again, like commodities, equities, forex, and bonds.

In its 2Q23 earnings call, the company highlighted some tailwinds. For example, the average daily volume ("ADV") across commodities increased by 20%, with a 34% growth in agricultural products, 27% growth in metals, and 9% in energy.

CME also emphasized the crucial role of options, with an ADV growth of 20% to 4.7 million contracts in Q2, including record agricultural options ADV, up 32% from the same quarter last year.

The company also touched on the rates market and commodity exports, causing increased demand for risk management using their benchmark products.

So, what about the valuation?

Valuation

CME Group is trading at 24.5x LTM free cash flow. It is trading at just 21.8x NTM free cash flow. This makes CME very attractive, especially in light of a high probability of prolonged above-average volatility.

As a result, shares have accelerated in recent days while the market has gone south.

The current consensus price target is $210, which is $1 below the current price.

I disagree with that and believe that the stock is between 15% and 20% undervalued. That's based on a 25x free cash flow multiple.

Hence, I'm a buyer. Over the next few months, I hope to see another dip in CME, which I can use to aggressively add to my position.

I believe that CME will suit me very well for decades to come, and I will use any opportunity to add - especially in this market environment.

Takeaway

In a challenging macroeconomic environment filled with uncertainty and economic complexities, one stock stands out as a resilient choice for dividend investors – CME Group.

This financial powerhouse operates differently from traditional banks and institutions, owning major exchanges and offering a wide range of futures and options contracts.

Its unique position as a primary price discovery provider and its asset-light business model make it a top-tier player in the market.

CME Group not only thrives during times of market volatility but also boasts a robust dividend history, with consistent growth and annual special dividends. With a base dividend yielding 2.1% and the potential for a 4.2% total dividend yield, it's a dividend investor's dream.

Moreover, CME Group's attractive valuation, trading at around 21.8x NTM free cash flow, presents an opportunity for savvy investors. As the market experiences heightened volatility, CME's prospects continue to shine.

In this turbulent market environment, I see CME Group as a long-term winner, and I'm ready to seize any opportunity to add to my position. With its resilience and dividend potential, CME Group is my top pick for financial dividend stocks.

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