CME - Exchange Operator CME Group Gets Neutral Rating Reaffirmed: A Strong But Expensive Earner

2023-11-19 00:00:32 ET

Summary

• CME Group gets hold/neutral rating from September reaffirmed after Q3 earnings results. Rating agrees with SA quant system consensus.
• Strong earnings and top-line growth, along with dividend growth and outperformance vs the S&P500 index.
• Challenges include below-average dividend yield and extremely overvalued, along with overbought share price.
• Risk of geopolitical tensions impacting trading have been discussed.

Stock Overview

In today's research note, I'll be doing my 2.5 month review of CME Group ( CME ) , within the financial exchanges sector, a stock I last covered in September before its most recent earnings result.

Since my last rating in September which called on holding the stock, it appears that I called it correctly as the share price has gone up nearly 5% since then (as of the writing of this article).

Today after applying my updated rating methodology and 13-point scoring system, I will be reaffirming my prior rating and give it a hold rating again this time.

Here are some interesting company points about this Chicago-based firm from its website and why I picked this stock to cover: calls itself world's leading derivatives marketplace enabling the trading of futures, options, cash and OTC markets. Offers markets data sets and data analytics solutions for clients. Also offers research and clearing services.

Rating Methodology

The stock's rating is based on its WholeScore , which is my approach to holistically rate a stock by considering 13 metrics of equal weight I think are relevant to investors and analysts. Key financial data presented is sourced from Seeking Alpha as well as the company's recent FY2023 Q3 earnings release that came out on Oct. 25th.

Revenue Growth vs Peers

The below table I created is a comparison of 5 peers I selected from the financial exchanges and data segment, to compare each other's year over year (YoY) revenue growth, as well as comparing my topic stock CME Group with the peer average.

In this comparison, we can see that it was actually Germany-based Deutsche Borse ( OTCPK:DBOEY ) that led the group in growth, whereas CME came in 2nd and beat the peer average by just over 3%.

I was looking for them to beat the peer average by 5% or better, so they missed a potential rating point here.

The nature of this business is that today's exchange operators are more diversified and make money on things like data, as mentioned earlier, in addition to transaction and listing fees on the exchanges they operate. So, exchange trading volume obviously matters.

CME has shown a strong growth position within this peer group. Here is what CEO Duffy had to say in his recent earnings comments :

CME Group delivered its ninth consecutive quarter of double-digit growth in adjusted earnings per share and a 9% increase in revenue as market participants continued turning to our markets to mitigate their business risks amid accelerating geopolitical uncertainty.

Revenue Growth (YoY)

From its current income statement , we see that CME achieved top-line revenue YoY growth of nearly 9% . My target was 5% or better, so it earned a rating point from me here for beating my target.

We already mentioned the strong revenue growth this firm has seen lately. However, I should also point out the revenue diversification of this firm, as shown in the pie chart:

One positive mention also is the growth in the market data segment, a multi-million dollar business for this firm, according to their Q3 release :

Market Data revenue in 3Q23 was a record $168 million, up 9% compared with 3Q22, due to the pricing adjustment that went into effect at the start of the year .

So far, the evidence shows that CME has proven to be a growth engine in its sector.

Earnings Growth (YoY)

Also from the income statement, it showed strength on earnings growth, achieving 10.3% on YoY net income growth.

This easily beat my target of a 5% growth, and earned another rating point here.

Since net income is impacted by expenses, good news is that the firm has adjusted some of its expense forecasts which I think is relevant to mention here for my readers:

Full year adjusted operating expense: "Lowering to $1.475 billion, a $15 million decrease."

Full year capital expenditures: "Lowering to $85 million", from prior estimate of $100MM.

So, because of this I remain positive about the next quarterly earnings result due in a few months on February 6th. Also consider that this firm managed beat all 4 of the last 4 earnings estimates .

Cashflow Growth (YoY)

The cashflow statement shows an amazing near 32% YoY growth in free cash flow per share.

My target was a 5% growth, so they easily beat it and earned another rating point here.

The reason I include a cash flow metric to track is that I believe a healthy business should be showing positive cash flow.

As a comparison among quarters, consider that only one out of the last 6 quarters has seen negative cash flow at this firm:

Equity Growth (YoY)

From the balance sheet , we see that positive equity growth declined only slightly by negative -0.35%, so we can say it was practically flat on a YoY basis.

However, since my target is a 5% or better YoY growth, it missed the goal and did not get a rating point in this category.

The good news in the equity space is that this company's long-term debt of $3.4B has not risen that much on a YoY basis, and practically flat since it was $3.4B in the same quarter a year ago too. I think this is a positive to mention, considering the high cost of debt nowadays.

3 Year Dividend Growth

When it comes to dividends , I am looking for a 3 year dividend growth of at least 5% or better. It may seem like an arbitrary amount, but I thought it would be both a simplified approach and a conservative one, seeking modest YoY growth.

In comparing the dividend rate from December 2023 of $1.10 per share with that of December 2020, it shows a 29.4% growth, easily beating my target.

Important to mention also is that the above comparison is for quarterly dividends only. This firm, however, also offers a special / other dividend as well, according to its history .

For example, in addition to its regular quarterly dividend in 2022 of $1 per share, it also offered a one-time dividend of $4.50 per share towards the end of the year. This is significant to me as a dividend-driven investor because not that many firms I have researched here offer special dividends, so when I find one it is worth adding to my "dividend quick picks" of the week.

According to the company's earnings release,

The company has returned over $22 billion to shareholders in the form of dividends since the implementation of the variable dividend policy in early 2012.

Dividend Yield vs Sector

In terms of the dividend yield, I am looking for a competitive one in comparison to the industry. In some sectors, like tech, many stocks don't pay a dividend at all. However, the financials sector is known to from what I've seen and in this case the forward yield is around 2%, somewhat below the sector average of 3.8%

It didn't get a rating point here as my target was for an above-average dividend yield.

It did however beat its peer in the exchange-operator space, Intercontinental Exchange ( ICE ), whose yield is just 1.50%.

I also would point out that the share price is very bullish on CME stock right now, which I will discuss in the next section, and so keep in mind if a price dip occurs that could push that dividend yield up, which is an opportunity I am waiting for, to snag a yield around 3.5% to 4%.

Share Price vs Moving Average

In this part, I will briefly talk about the share price itself in relation to the 200-day simple moving average, and whether I think it presents a great buying price now or not.

To do so, I picked a buy low/sell high trading strategy where I am looking for price dips below the 200 day average. As the chart shows, the last time this happened was back in the spring. Since mid-summer or so, the share price has traded well above this moving average.

If you look at my table below, you can see that the share price as of this article writing is over 10% above the moving average I am tracking.

Since it does not fit my buy/sell strategy, I am not giving it a rating point here and will call it overpriced for now. Hopefully, I will see a dip into the $180 to $193 price range, which presents a better buying range in my opinion.

Something that could trigger that type of selloff in this stock is a significant earnings miss for Q4, which is questionable since earnings so far have been strong and so is the company outlook, as well as the last several earnings beats. I am also not sure that there is a catalyst to drive the price significantly more upward from here right now.

Fellow exchange operator Intercontinental Exchange is trading at just around $112 per share, and only slightly above the 200 day average. So, there are cheaper options in this sector. When comparing the income statements of the two, Intercontinental Exchange also saw YoY revenue and earnings growth, as well as a cash flow statement showing YoY growth there too.

Price Return vs S&P500

The market momentum of this stock has been impressive, beating the S&P500 index in terms of 1 year price return, to the tune of a 77% outperformance vs the index!

In comparing 3 of the peers in my peer group, CBOE Global Markets ( CBOE ), CME Group, and Intercontinental Exchange all saw positive 1 year performance of at between 7% and 45%, according to Seeking Alpha data on this sector .

So, this tells a story of market confidence in the exchange operators as a subsegment of financials, even though banks themselves took a hit this spring, but obviously exchanges are not banks.

I wrote many months ago in a Seeking Alpha article that I see value in the exchange operators since on the one hand they make much of modern trading possible but also earn fees regardless of whether your own trade wins or loses.

P/E Ratio

When it comes to valuation , one metric I care about is the forward price to earnings ratio because it tells me if the market is willing to pay a high premium vs earnings, or not.

In this case, the market is pricing this stock at almost 25x earnings, as my table shows, even though the industry average in this sector is under 10x earnings. Highly overvalued , I think.

But what is driving such a high valuation in my opinion?

Even though earnings have improved on a YoY basis, it seems the evidence shows price has really skyrocketed into bullish territory, so I think the "P" side of this ratio is what is driving it up, another reason I find this stock to be overbought right now.

This should come down as the earnings continue to rise and the price takes a dip. That may be a hard ask right now if the market bulls continue to chase this otherwise really attractive company in my opinion.

P/B Ratio

A similar scenario seems to be happening when talking about the forward price to book value, with the ratio of 2.77x book value being over 163% above average and highly overvalued. My target for both valuation ratios was an undervaluation or at worst a slight overvaluation near the average.

I think the equity / book value being relatively the same on a YoY basis, as mentioned earlier, while the share price is into overdrive mode, can be what is driving this metric.

What can help this case is if the price takes a dip while the equity improves, and that is hard to predict exactly at this point.

In the comments section, I welcome your thoughts on whether you consider this stock overvalued and why or why not?

Return on Equity

In looking at the return on equity , I am focusing on the trailing twelve month return on common equity, as a relevant metric. In this case, the firm achieved a nearly 11% return, but missed its sector average by 8.4%, and also missed a rating point from me since my target was 5% or more above the average.

However, it is not that far below the average, and is not a terrible number either.

It did better in this metric than its peer Intercontinental Exchange, whose return was 10.12%.

Risk Score

Unlike banks, a financial exchange operator does not have some of the same risk exposures such as exposure to bad loans or declining bond portfolio values, or exposure to uninsured deposits and the risk of a bank run.

So, because this company's largest business segment is running an exchange that depends on trading volume, a risk would be a drop in investing volume, such as investor jitters surrounding two geopolitical wars going on simultaneously, or perhaps an extended recession leading to less investing /trading and more hoarding of cash.

However, right now no certainty of recession has been announced, and the geopolitical tensions seem to have benefited this firm in terms of trading certain items, according to their Q3 presentation :

Third quarter showed strong performance across all Agricultural products. Geopolitical tensions , renewable fuel demand and export trends have contributed to significant growth in options volumes across the Grain & Oilseed complex.

CME Group’s Crude Oil suite of products provide market participants with tools to express their directional views on the market and manage their price related risk, made for a strong September and 3Q as global crude oil supply worries combined with high demand led to increased oil prices.

So, I would say the risk for this firm is low, and therefore I will not take reduce their overall rating because of a significant risk I know of.

In this case, I gave it a Risk Score of 5, seeing that the risk impact is low and risk probability of geopolitical tensions is medium to high.

WholeScore Rating

This stock got a WholeScore of 5 in today's rating, earning a rating of hold / neutral from me.

In comparing my rating to that of the consensus , I am agreeing this time with the SA quant system which shows a "hold" consensus today, while I think the "buy" consensus from Wall Street and SA analysts is overly bullish.

Summary and Forward Outlook

To summarize, I am reaffirming my hold rating on this stock from last time and my sentiment is neutral: I think it is too valuable to sell despite the high price but that is also a reason that it does not present a great buy right now either. It is not clear if the price will dip soon or not, but also I don't see a catalyst to drive it up a lot higher than it is.

As a dividend income stream, it would be a decent addition to my portfolio of financial-sector stocks, if I was holding this one, to have exposure to the exchanges and "own a piece of the exchange" as I like to put it. After all, the market for trading options, futures, commodities, and so on is a multi-billion-dollar a year industry.

So, for now a dividend quick pick and reliable earner but an expensive one!

For further details see:

Exchange Operator CME Group Gets Neutral Rating Reaffirmed: A Strong But Expensive Earner