Yesterday, we reiterated our recommendation on CME Group Inc. (CME) at Neutral based on the critical sustainability factor. The company’s fourth quarter earnings missed the Zacks Consensus Estimate on higher operating, interest and tax expenses coupled with reduced average rate per contract. However, earnings were higher over the prior-year period on considerable top-line growth.
CME Group continues to post modest average volumes with significant growth across the entire product spectrum. Currently, CME holds 98% market share of the US futures trading with a clearing house notional value of about $30 trillion. We expect this increasing trend in volumes to continue along with substantial leverage from over 200 products launched in 2010.
While increased electronic trading volume adds scalability (and hence leverage) to CME Group’s operating model, it also helped the company to maintain an operating margin of over 60% coupled with consistent bottom-line growth, for the last three years. Besides, the BM&F and the over-the-counter (OTC) offerings are expected to contribute modestly to the top-line growth in 2011.
Moreover, the launch of Financial Instruments Clearing Membership (FICM) will offer cost-efficiency to traders through reduced margin requirements and augment the cross-selling activity within CME’s interest rate futures.
Additionally, FICM will provide a significant competitive advantage primarily from NYSE Euronext Inc.’s (NYX) New York Portfolio Clearing (NYPC), which is based on similar cross-margining between Eurodollar and US Treasury Futures and is likely to be operational from late first quarter of 2011.
Additionally, CME Group’s core business is improving consistently. Globex volume continues to grow to form a major part of the exchange’s total trading volume (from 57% in 2004 to 80% in 2008, 81% in 2009 and 83% in 2010).
Although 2011 could be slightly mild due to the absence of newer initiatives and regulatory uncertainties, we remain positive on Globex volume growth given the company’s ongoing initiative of providing co-location services is also expected to add $30–$40 million in revenue from 2012 onwards.
Profitable growth in clearing and transaction fees and services is another key element, representing 82.8% of CME Group’s revenue in 2010 and improving from 2% year-over-year growth in 2009 to 15% growth in 2010, primarily driven by NYMEX products and CME ClearPort services.
The operation of CME Clearing Europe by the first half of 2011 is further expected to accentuate the multi-asset class OTC clearing services, along with an intense penetration in emerging markets of Europe.
The strategic acquisitions and alliances are further expected to strengthen and diversify CME Group’s revenue streams including the rapidly growing energy segment, expand its index and market data offerings and fuel further growth opportunities in the equity index.
Given the significant ongoing consolidation activity in the industry, we foresee a notable acquisition in the near future in order to enhance the company’s competitive leverage and increase its non-US volume by spreading its global footprint.
The global economic recovery has also helped CME Group to reduce its total debt to $2.5 billion at the end of 2010 from $3.3 billion in 2008, while also increasing its operating cash flow by 25% from 2009 to $1.36 billion in 2010. Going forward, the substantial free cash generation from the business has also amplified the scope for share buybacks and special dividend in 2011, thereby adding to the company’s financial flexibility and investors’ confidence.
However, increased compensation and benefits led total expenses to increase 14.5% year over year in 2010 after a 4.6% growth in 2009. Followed by higher expense guidance for 2011, a rising trend in expenses has elevated the operating risk and switched to negatively impact the bottom-line growth. Additionally, the trading activity is inherently variable, both seasonally and cyclically.
Further, CME Group’s diversified product portfolio is exposed to extreme interest rate volatility and limited credit availability significantly in the current unstable capital and credit markets. This can hamper liquidity and can also cause a decline in the customer demand if this trade scenario continues or worsens in future. The European credit crisis in early 2010 has also raised uncertainty around the LIBOR rate. Even the average rate per contract for futures and options shall continue to exert pressure on revenue growth in the near term.
Besides, the ongoing consolidation in the industry has raised caution over the sustainability factor of the sturdy groups too and puts up an uphill battle to gain market share. An uncertain regulatory environment amid such volatile macro factors has caused additional furore in the industry and are expected to slow down volumes growth of CME at least by the beginning of the second half of 2011, when the details of the regulations are released and rules enforced.
Overall, we believe that despite the near-term regulatory and higher spending hurdles, CME Group’s efforts to promote, expand and cross-sell its core exchange-traded business through meaningful acquisitions, newer product initiatives along with its global presence will generate a decent growth in the long run.
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