CME - CME Group: What Could Make This Monopoly Compelling To Own

2023-12-28 05:40:10 ET

Summary

• CME Group has been a beneficiary of the robust growth of the futures market over the past decade, holding a monopoly-like position.
• CME's fundamentals are heavily influenced by contract volume and the company has not exercised pricing power.
• CME trades at a fair multiple and has several paths forward, some more positive for shareholders than others.
• Investors should closely monitor future developments, flexing pricing power could increase the stock price, while reckless M&A could lower the stock price.

Industry:

Most durable growers are businesses that receive outsized benefits from economic development. CME Group (CME) was created in 2007 in a merger between the Chicago Mercantile Exchange and the Chicago Board of Trade, and has been a clear beneficiary from the robust growth of the futures market.

CME Group powers futures and options markets, allowing businesses exposed to volatile prices to exchange goods at fixed prices in order to manage risk, while also allowing speculators to participate. The biggest risks that futures and options markets enable hedges against are movement in interest rates, equity markets, foreign exchange, energy prices, commodities, and metals.

This is a crucial service. Budgeting teams at companies that are highly levered, or sell a volatile commodity must still have some visibility into the future in order to make sure the business is able to manage expenses. It's also important to create exchanges that enable prices to be efficiently kept.

At a high level, the industry key metric is the number of contracts traded and the revenue collected per contract. In 3Q'13 CME's average daily volume was 11.1M contracts, and its rate per contract was $0.762. Last quarter, one decade later, volume was 22.3M contracts with a rate of $0.707. CME's total quarterly revenue has grown from $715M to $1,338M in the same period.

This wider lens tells us a few things: CME's fundamentals are heavily dictated by where contract volume goes, and CME has been able to exercise very little pricing power over the past decade. The first is primarily a question of industry dynamics, while the second is a question of competitive positioning.

There's a number of variables to consider when forecasting future contract volume. The first is simply the overall size of the economy. With more market participants, there is a greater need for hedging risk. It's also important to consider the overall risk appetite as businesses get smarter and better understand their risks. For example, many information service providers have recently been investing in expanding data in relation to climate change. This could be an accelerant for CME in the future, new derivatives may be created for businesses heavily exposed to climate change to hedge their risks.

Competitive Positioning:

Our deep, liquid markets; diverse and complementary product offerings; frequency and quality of new product development; and efficient, secure settlement, clearing and support services, distinguish us from others in the industry.

CME has held a virtual monopoly on futures since its creation. CME holds exclusive licensing for exchange for equity indexes futures, highlighted by the S&P 500 e-mini futures.

Walter Mattli has argued that competition amongst exchanges is a net negative overall, making markets much more difficult to police. He believes the loss of market share for the NYSE has made it much easier for abuse by bad actors, in contrast with CME who can monitor all activity much easier.

Whenever a business has a stranglehold on an essential market and consistently generates profits, the stock is always a buy at some price, but the competitiveness of the modern market gives little room for error.

Capital Allocation :

CME's method of returning capital is through its variable dividend policy. Essentially, they issue a regular quarterly dividend and an annual special dividend each December. CME has returned $22B to shareholders since 2012.

Overall, investors should be critical of set it and forget it capital allocation plans. During different times, different playbooks make sense. Buybacks, when a share price is undervalued, are often the best form of capital allocation. Dividends are fine when stock prices are expensive, but investors are double taxed.

Decisions on how to reinvest in the business are much more complicated and harder for investors to decipher. It's also a bit concerning CME's CEO has alluded to making acquisitions . This is less than a few months after Nasdaq's abhorrent decision to di-worsify its business with a massive $10B acquisition of Adenza . CME should be very conscious of eliminating unforced errors like this.

Valuation:

CME trades at about 23x TTM earnings on both GAAP and FCF metrics. The US 10-year treasury trades around 3.8%, meaning CME is slightly cheaper than treasuries. While the general theory is treasuries deserve to trade at a premium because of their risk profile, CME's competitive position is so strong, it will trade at a higher multiple because of its lower risk.

Looking ahead, the conservative 5-year forecast entails just a continuation of long term trends. Estimating the number of contracts will double each decade without any growth in pricing, and consistency in margin structure is the most likely forecast. Should that unfold and multiples stay in the same neighborhood, CME Group is looking at high single digit returns, in-line with historical market performance.

What Could Make CME Compelling:

CME is the most interesting of the exchanges because of its monopoly position in futures. But fringe valuations and modest growth projections don't usually proceed massive outperformance. To really juice returns on CME, investors would need to see a lower share price or management actions that drive fundamental outperformance. At $180/share, CME would roughly trade at 20x trailing earnings, a growing 5% yield would make the stock more enticing.

The most significant development would be management showing they're willing and able to raise its rates per contract. CME Group has gone a decade without taking any price, similar to how Fair Isaac (FICO) didn't for decades on its scores either. When they began raising prices, the fundamentals have greatly improved and the stock price has followed. Because of CME's grip on the futures market, it seems more likely for them over other exchanges.

On the other hand, if CME were to take more reckless actions, such as poor M&A, the stock price could easily be pressured and underperform. M&A makes little sense for monopolies, buying businesses that are not monopolies is more likely to result in margin compression and reduced shareholder returns. CME is a great stock to add to a watchlist and carefully follow how the trajectory changes. A few positive signals in the right direction could make the stock into a compelling buy.

For further details see: