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CME Group/Bryan Ives, MEDILL

CME Group's trading volume and revenues follow similar paths.


Future CME earnings seen as steady amid low rates

by Bryan Ives
Apr 30, 2013


After years of remarkable growth in trade volume and revenues since CME Group Inc. went public in 2002, the Chicago-based derivatives exchange now must settle for minimal revenue increases in the foreseeable due to low fed funds rates and a slow-growing economy, in the view of analysts covering the company.

They give a 12-month target price of $61.59 for CME Group stock, just a hair over its Tuesday closing price of $60.86. The stock has fluctuated between $49.54 and $63.63 over the past 52 weeks.

In 2012 CME earned $896 million, or $2.70 per diluted share, down a whopping 51 percent from 2011 earnings and 6 percent below 2010 earnings. Analysts estimate $3.16 per share for this year.

CME generated $2.92 billion in revenues last year, including $660.9 million in the fourth quarter, just 0.17 percent below final quarter estimates. But revenues totaled $3.8 billion in 2011 and $3 billion in 2010.
 
The bulk of CME’s revenues come from fees collected on each transaction made in its electronic system or on the trading floor. Therefore, the greater the volume of trades, the more revenue the company earns.

“Fundamentally, by the end of the quarter or a few days afterwards, you pretty much know what they’re going to make,” said Brad Hintz, an analyst at Sanford C. Bernstein & Co. who rates CME a “buy.” “The earnings are not going to be a surprise.”

Earnings are accurately predicted, he explained, by tracking the daily trade volume released by CME. Multiplying the daily volume by the revenue per trade followed by the number of days in the quarter gives an accurate prediction of CME’s quarterly revenues.

CME's goal is to maximize the number of trades it executes. However, this is largely out of the hands of the exchange.

According to Hintz, a large portion of CME’s trade volume comes from Treasury futures, which are largely dependent on federal fund rates controlled by the Federal Open Market Committee. Rising interest rates, a sign of a growing economy, lead to increased trade volume and earnings for CME.
But the FOMC has consistently stated it intends to hold interest rates at their present low level for some time into the future.

Among CME’s top interest rate products are 10-year and 5-year Treasury futures and options. In 2012, CME averaged 4.84 million interest rate product transactions per month, which was approximately 42 percent of CME's trade volume.

“In many ways when you think of CME you should think of it as an anticipatory bet on rising rates, and rates only rise if the economy is doing better, so fundamentally you could say that CME is a leverage bet on a recovering U.S. economy and a change in monetary policy,” Hintz said.

“In fact, arguably it’s pretty much the most rate sensitive stock that exists.”

With the fed funds rate--the rate at which banks make overnight loans to each other--currently between 0 and 0.25 percent, it appears there is nowhere to go but up. Any jump in rates would signal a positive future for CME, which holds a 98 percent market share in U.S. dollar interest rate futures, according to Hintz.

However, most analysts accept that the FOMC is unlikely to bump up rates in the near future due to a slow growing economy, likely preventing any spike in trading volume at CME.

The long-term expectation of low interest rates is a reason why nine of 23 analysts rate CME shares a “hold.” Additionally, nine analysts rate CME a “buy” and five rate it a “sell.” Such a wide discrepancy amongst analysts is unusual.

“Essentially no one can predict where interest rates can go but we’re anticipating that it’s going to be a ways down the road before we see an increase in interest rates,” said Shannon Stemm, an equity analyst at Edward Jones, who rates CME a “hold.” “So not a 2013 event and that’s essentially what we’ve modeled in, and as such we think that it’s likely that activity stays somewhat muted.”

CME Group is currently the second largest exchange group in the world and the largest in the United States as measured by market cap. The company brings buyers and sellers of futures, options and other derivatives together via its electronic trading system and trading floors.

In addition to the Chicago Mercantile Exchange, CME Group comprises the Chicago Board of Trade, which was founded in 1848 as the Chicago Butter and Egg Board, the New York Mercantile Exchange and other exchanges. It also operates trading hubs in Europe and has connections to Asia.

Consensus analyst estimates expect CME to generate $2.97 billion in revenue this year, a 2 percent increase from 2012. This is a reflection of the belief that fed funds rates are unlikely to rise this year, thus keeping trade volume and revenues at similar numbers to last year.

In addition to the unlikelihood of interest rates rising in the near future, increased competition within in the industry adds uncertainty to the future of CME.
 
In Dec. 2012, Atlanta-based IntercontinentalExchange Inc. (ICE), another publicly traded derivatives exchange, announced its intention to purchase NYSE Euronext (NYX) for $8 billion. The deal is still pending regulatory approval but would make ICE the third largest exchange group in the world, behind CME and a Hong Kong Exchanges and Clearing.

“CME currently dominates in the interest rate derivatives market and we think this new company has the potential to kind of challenge CME’s market position,” Stemm said. “Only time will tell whether or not that’s true, but certainly competition has been heating up in this phase.”

CME has maintained a presence in Europe since 1979 when it opened an operation in London. However, in the months since the acquisition announcement by ICE, CME has introduced two new natural gas contracts as well as interest rate swaps in Europe.

Many view the larger ICE presence as a threat to CME’s market share in Europe.

“That’s going to make a formidable competitor to CME,” said Ken Leon, an analyst at S&P Capital IQ, who rates shares a “buy.” “Not necessarily product to product but ICE will be taking up a very attractive derivatives business in Europe from NYSE.”

A final question surrounding not only CME but also the entire exchange industry is the impact of increased government regulation. The Dodd-Frank Act, signed into federal law by President Barack Obama in 2010, is a set of regulations for the financial services industry following the economic crisis in 2008.

Part of the law stipulates that over-the-counter, or non-exchange, derivative trades must be cleared by an exchange. This is due to the fact that over-the-counter trades do not have to follow the stringent rules of an exchange.

The rules are currently being implemented in stages. Mandatory clearings for active hedge funds, managed service providers and swap dealers began in March. On June 11, non-dealer banks, insurance companies and non-active hedge funds will be required to clear through an exchange, and on Sept. 11 the Dodd-Frank regulations go into effect for other customer groups. The process will be complete by the end of 2013.

Some analysts believe the mandates from Dodd-Frank will force more business to exchanges while others think it could simply be a reason for non-member companies to avoid exchanges all together.

“It’ll be interesting to see if a lot of additional activity going on to the exchanges or if clients just say, ‘I don’t want to do that. I’ll just structure a future contract instead and then I can go ahead and continue over the counter trading.’” Stemm said.

 

Looking forward, there are too many questions about the future of CME and the exchanges industry to expect a generally accepted consensus on the future of CME shares. The company continues to operate with impressive balance sheets, but until interest rates rise and the impact of ICE’s potential acquisition of NYX as well as the regulations from Dodd-Frank are firmly established, CME stock will remain a divisive subject.