CME operates a derivative exchange that allows the trading of futures and options contracts (although has recently expanded into cash trading) for a variety of asset classes including interest rates, stock indices, energy, agricultural commodities, precious metals and foreign exchange. There are two core competitive advantages that CME benefits from, underpinning compounding earnings growth over the long term:
- Network effects: Like most marketplaces, the value of CME to market participants increases as usage of the platform (volumes) increases. It is this feature that makes the marketplace so sticky for customers and difficult to dislodge for competitors. CME is the largest futures exchange globally with dominant positions in a range of contracts spanning different asset classes. This superior liquidity is a strong deterrent for CME customers from leaving as even if competitors offer better pricing, average daily volume constraints may result in alternate, shallower pools of liquidity being impractical to deal in and leave orders unfulfilled.
- Switching costs: Somewhat intertwined with CME’s network effects, users who seek out alternate platforms effectively will pay for it through a wider bid-ask spread and slippage costs. As a result, even if competitors offering superior pricing on contracts traded, market participants may still pay a greater total transaction cost. A new entrant would need to consistently subsidise market participant’s losses for it to be economically attractive for them to entertain another platform for an extended period of time, rendering competition in many contracts improbable and challenging. The economic switching costs are reinforced on some contracts by strong logistical benefits arising from regional differences – such as physical costs of delivery to geographically distant exchanges, language barriers, regulatory complexities – that further discourage customers from using other exchanges located in different regions.
CME’s attractive market structure and strong competitive advantages underpins stable earnings growth, driven by structural tailwinds associated with futures trading in a number of its key asset classes. These features are further reinforced by a number of attractive operating characteristics.
- Diversified portfolio – CME’s exposure to a range of asset classes lead to a well-diversified business that ensures that at least a part of its portfolio will benefit from the vast majority of macro-economic environments. This underpins a dependable revenue growth stream.
- Track record of margin expansion – A 15-year period of strong volume growth and stable pricing has generated significant revenue growth since listing. CME has benefitted from positive jaws, managing a largely fixed cost base accompanied by solid top line growth which has underpinned strong underlying margin expansion.
- High returns on capital – CME’s return on capital of >30% (Return on Tangible capital >90%) make it a desirable, capital light investment. The business requires very little working capital or capital expenditure to drive greater volumes in future years, leading to increasingly high levels of asset efficiency and an extremely high return on incremental capital deployed.
- Highly free cashflow generative – the capital light nature and extraordinary margin profile of CME’s operating model leads to significant free cashflow generation. CME pays out 50-60% of earnings as dividends and is currently yielding 3.6%
- Shareholder aligned management team – Terrence Duffy has been on the board of CME since 1985 and in senior management roles since listing in 2002. He has a strong record of delivering on his messaging to the market and superb capital allocation, evidenced by a handful of accretive acquisitions over the past 15 years.
Intro – Why Futures exchanges and why Chicago Mercantile Exchange?
Many of the features described above could be applied to other marketplaces or exchanges. There are two important questions that must be answered to determine why CME is more attractive than many alternate stocks in the global exchange universe:
Why are futures/options more attractive for investors than those that enable cash equities trading?
Since the mid 90’s the number of listed companies has shrunk dramatically in developed markets. Between 1996 and 2016, the number of listed companies fell by half, to 3,600, down from 7,300. Additionally, the number of listed companies and initial public offerings in the U.S., the U.K. and the Eurozone has been on a steady decline since the heady days of the dotcom boom. To that point, activity peaked in the U.S. in 1996, with nearly 700 IPOs. By 2017, that number was barely 100, according to CFA Institute research. There are a number of factors driving this including greater regulatory requirements of publicly listing, lower growth in developed countries, shifts towards less capital intensive technological businesses and perhaps most importantly, reduced friction accessing capital in private markets.
Regardless of the rationale, the clear decline in public listing volumes appears at least partly structural which provides two major ongoing earnings headwinds for exchanges – less primary market activity fees and fewer transaction fee revenues.
Secondly, equity exchanges are exposed to competition across a number of regions – many new IPOs (particularly ‘popular’ ones) will chose to list in the US which undermines regional exchanges ability to grow. TEAM is an example of a high profile Australian IPO that spurned the local exchange in favour of the Nasdaq and there are many other examples. There are 13 approved futures exchanges in the US that have consolidated into three publicly listed companies – ICE, NDAQ, CBOE. But there are many other trading venues outside these exchanges, testament to lower entry barriers brought on by electronic trading.
Futures exchanges have remained more immune to competition due to oft referenced benchmarks that have effectively created their own proprietary market (Brent, Libor, VIX etc.) Competitors such as Nasdaq OMX and Shanghai International Energy Exchange (INE) have tried to break into the market in the past although ultimately have not been able to break the comfortable duopoly for US assets that exists between CME and ICE. This is largely due to the deep liquidity pools that have arisen in certain contracts, creating a strong moat for futures exchanges. Therefore, the cash equity exchange is a more commoditised business than what we will see in in futures exchanges in addition to secular growth concerns.
Why is CME a more attractive proposition than CBOE and ICE?
Futures exchanges represent a more appealing investment as they benefit from structural tailwinds. Advantages for market participants in futures markets are plentiful – standardised contracts increase liquidity, margin structures enable lower levels of capital intensity and lower transaction costs – which underpins GDP-plus growth over the long term.
There is less competition amongst futures exchanges, both in absolute numbers but also within certain asset classes and contract verticals. As a result, the major US futures exchanges have trended towards high levels of market share within their specific verticals as extremely strong network effects have driven a concentration of trading – the network effect is so strong that contracts opened on a future exchange can only be closed on that exchange and as such open interest tends to be a pretty solid lead indicator for future revenue growth.
ICE and CBOE tend to have a greater earnings contribution arising from cash trading, single stock options, and/or data fees. These segments do not benefit from the same structural tailwinds as futures trading, face regulatory headwinds capping price growth, or are significantly more competitive than the core exchange business. For instance, ICE’s Desktops & Connectivity data segment competes with Bloomberg, Thomson Reuters and Factset as a general financial terminal with a large range of context, tools, and analytics. The moat in the provision of data is much more difficult to identify.
The graph below demonstrates the rapid structural growth futures market have experienced over the past decade. As we will come to see, the fastest growth derivative products started the decade as much less commonly traded than single stock equities or Equity indexes. This is leading to a positive mix effect for futures and options as these asset classes continue to grow and encompass a larger percentage of overall volumes.
CME: Assessing the moat within each product
CME has experienced disparate growth rates across its different asset classes however, the largest absolute volume areas over the past decade have been Interest Rates, Equities and Energy. Unless specified otherwise, I have excluded 2020 Q1 & Q2 from my analysis which features an artificial spike in volumes as a result of the covid crisis.
To get a better understanding of CME’s market share strength it is worth considering how the rate per contract has trended over the past decade. At first glance, Interest rates and Metals appears to be the only two out of CME’s segments that have held pricing steady but other products (e.g. equities) have held pricing steady but the mix of contracts within the asset class has changed. I will go into this in greater detail when discussing each asset class.
The change in rate per contract is generally illustrative of the areas where CME has the most market power. I.e. The most competitive asset classes are the ones that have experienced the greatest price compression. As a result, some of these areas that have historically been a small part of the asset mix such as Metals are growing rapidly and by 2030 will contribute meaningfully to CME’s growth profile while other areas such as Energy will likely decline in materiality over the coming decade.
CME has three main products in this asset classes – Eurodollar, US Treasuries and Federal funds – that span across a range of maturities. US interest rate futures and options can essentially only be traded on CME – at least in the size required by an institutional/ corporate / government market participant. Competitors such as the Nasdaq have attempted to take share in the past but have been unable to garner sufficient market share (liquidity) that major market participants could justify leaving CME’s exchanges… even when significant discounts were offered. This forms an extremely powerful network underpinned by slippage (switching) costs that reinforces CME’s incumbency.
CME has grown volumes steadily at 7.3% per annum since 2010 while pricing has remained broadly flat over the past decade, translating to significant earnings growth. The pricing dynamic is reflective of the monopoly that CME has in its major Rates products. This is reinforced by the below figure detailing the top 25 Interest Rates Futures and Options contracts globally. Simply put, CME dominates market share across nearly all Rates products that it offers but particularly so amongst US products. Market participants must pay an invisible slippage ‘tax’ to trade on alternate platforms as a result of the inferior liquidity offered. The length of time required for a competitor to develop a desirable level of liquidity would likely require years of sustained losses through promotions – if the new competitor were unwilling to commit to this process, there would be no economic incentive for CME’s userbase to switch. This segment accounts for 37% of CME’s revenue and has been the major driver behind the growth story since 2010.
Growth in interest rate volumes over the past decade has been heavily influenced by QE – when the Fed abandons such heavy handed monetary policy, interest rate volumes begin to rise adding volatility to the rates complex and translating to strong demand for a number of CME’s interest rate futures products – particularly at the front end of the curve. The chart below denotes all products aggregated by volume and highlights a) The relative decline in dealer volumes due to post GFC regulatory changes b) Increased asset manager and leveraged money participation in 2016/17 as the Fed Funds Rate begins to rise.
This is a cyclical driver of volumes for CME and unfortunately for investors, QE has returned in the aftermath of the coronacrisis. This has played a role in CME’s underperformance relative to the broader market since April. There are however structural tailwinds to the rates complex as futures volumes now supersede cash Treasury volumes. The benefits of futures over cash markets leading to this structural growth was discussed earlier.
An increase in market participants needing to hedge their exposure is indicative of increased market depth that has been in large part driven by asset managers and leveraged money. Increased depth is reflective of a larger network that exists and reinforces CME’s moat.
The role of interest rate volatility/ uncertainty in driving volumes for CME is further reflected by the below figure which represents the dramatic decline in volumes for the two-year Treasury futures market in March. This shows that when the Fed next ends its QE program there will be a large amount of market participants that will re-enter the market as speculators leading to a return to volume growth.
By contrast, 10-year Treasury futures have not yet felt the same sharp decrease in volumes which highlights that uncertainty surrounding interest rates at the exercise date of the futures contract is pivotal to volumes for CME. The most active group remains asset managers (red) and even leveraged money volumes (green) have not yet declined in a meaningful way. Since QE was last implemented by the Fed, CME has diversified its exposure and is less reliant on short dated futures contracts for revenue which should ensure more robust volumes when compared to the aftermath of the GFC. Further, the sheer number of treasuries issued during this crisis will lead to a structurally higher volume of hedging required when volatility does eventually return.
A downside scenario
Taking a closer look at the post GFC case study is informative. The precedent is complicated by the fact that the Fed went through multiple rounds of QE over a 5 year period before average daily volumes returned to 2007 levels. Comparing this experience to 2020, we have skipped 2 years of policy uncertainty to essentially be in an environment that most closely resembles 2009 with seemingly unbounded QE. The Federal reserve has learned from past experiences and the reaction this time has been more extreme (and swift) than the GFC case study. As a result, I have used the recovery in volumes from Jan 2009 – Jan 2012 as my base case to forecast a period of dramatically reduced volumes (up to 50% declines in some products) before an eventual recovery to previous peaks.
This results in the previous highs being reached in FY24 which I believe is conservative given a) the sheer level of the stimulus this time and b) the unusual nature of the Coronavirus induced recession which will likely lead to a sharper recovery when economies are re-opened and/or a vaccine is found. As noted above, CME’s greater diversification within the rates complex should lead to a more robust revenue outcome this crisis however to be conservative, I have virtually discounted this positive mix effect on volumes by leaning heavily on the GFC experience. This leads to a forecasted revenue CAGR of 7.9% through the 2020’s, below the 9.8% CAGR of the past decade but still demonstrating a healthy bounce back from 2025 onwards.
BrokerTec is a global electronic platform for the trading of fixed income products, with a leading position in cash U.S. Treasuries, as well as activity in European government bonds and E.U. and U.S. repo fixed income instruments. It facilitates trading principally for banks and non-bank professional trading firms. The cash market for US treasuries is structured very differently from futures markets, featuring a network of 20-25 ‘wholesale’ dealers that can buy and sell treasuries directly from the US Government to provide liquidity to institutional investors. Brokertec intermediates 80% of these trades, creating a similarly strong network effect to CME’s interest rate futures business.
This benefit of the acquisition is twofold. Naturally there are significant cost synergies in the trade settlement and technological infrastructure required to operate both businesses. Management has identified $200mn in synergies that will be achieved by 2021. Unlike other acquisitions where synergies can be doubtful, I believe there is strong overlap amongst technology & people required to run a Treasuries exchange and as a result, I have assumed the full $200mn benefit in my forecast cost base. Secondly, there are substantial cross selling synergies available between clients trading cash, futures and options which will present further revenue growth opportunities. I have not included any benefit for revenue synergies.
This is an acquisition in a comparable industry to CME’s core rates business and as a result, will benefit from comparable network effects and the high switching costs that cement its position as the dominant player in futures markets. However, the cash business is not a core driver of my thesis due to the lack of historical growth and small revenue contribution (<10%.) CME paid just under $5bn for the acquisition for an EBIT multiple of 14x (post synergies) which is relatively undemanding – even if the business functions purely as a capital-light producer of free cash flow but offers limited future growth, it will be a worthwhile investment.
The Agricultural commodities segment has generated 7% volume growth for CME since 2010 while Rate per contract has held steady over the period. The volume growth has been driven by the structural growth of agricultural derivative contracts as a more efficient and capital light manner of hedging exposures. The use of agricultural derivatives globally has grown at 7.4% CAGR since 2009, in line with CME’s volume performance.
CME primarily trades corn, soybean and wheat – all staples in US primary industry. There is little incentive for market participants to switch as many of CME’s customers are ‘real money’ corporates. They utilize the exchange for hedging purposes and competing offers in different countries (and currencies) brings risks and complexity that these participants have no interest in bearing. As a result, CME has a captive userbase, using these products for primarily functional purposes. This accounts for ~10% of CME’s revenues currently however, by 2030 I forecast this to encompass a more meaningful 16% of Futures revenue. CME’s strong market position is reflected by its high levels of market share across its core commodities. Agricultural commodities are highly regionalized and usage is dependent on local weather conditions and food preferences. As a result, the US market features far more market participants than other global regions when it comes to Corn, Soybean and Wheat (highlighted below in Orange.)
The only other region with comparable volumes in these categories is China (highlighted blue.) There are a couple factors in the above figure that ensure CME’s market share is underrepresented:
- Different contract sizes – To be perfectly hedged against 1 CBOT Soybean, a Dalian Commodity Exchange trader would need to Short 11 DCE Soybean Meal and 2 DCE Soybean Oil contracts. When these volumes are adjusted for, CME has nearly 3 times the notional value traded vs. the Dalian exchange in Soybean contracts and greater than that differential in Corn contracts.
- The regional effect – it is highly unlikely US (or other DM) hedgers would desire the FX risk or geopolitical risk associated with Chinese futures contracts. There are significant additional costs incurred in delivery of the underlying commodity which make the use of China’s agricultural features impractical. Different standards around delivery requirements, regulatory differences, transport costs, language barriers and convenience are all examples of prohibitive factors that ensure participation from ‘real’ users of agricultural derivatives will likely remain regionalised.
Omitting Chinese exchanges as viable alternatives reveals a distinct lack of competition within the top 40 most traded agricultural futures and options contracts. CME has strong volume advantages across Corn (trades at a minimum 30x more volume than its nearest western competitor) and Soybean (trades at a minimum 20x more volume than its nearest western competitor.) I could go further into the highlighted CME agricultural products although the message is clear – CME dominates the western world trading of agricultural derivatives with respect to its core products. It is an entrenched and reinforcing network effect that would be extremely difficult to disrupt for a new entrant. As a result, my forecasts lead to 6.9% revenue growth in agricultural derivatives – in line with the previous decade but slightly below aggregate market growth.
It is worth briefly highlighting the source of demand across CME’s most popular contracts – Corn and Soybean. The chart below demonstrates the significant participation from ‘real’ economic users as opposed to the speculators found in other asset classes. The growth will be underpinned by ~3% production growth across US agriculture complemented by structural tailwinds provided by the financial flexibility and operational certainty provided by the use of futures contracts. Risk management will only become more relevant in futures years as the effects of climate change increase production volatility and generate additional uncertainty for primary producers. However, I have not assumed any acceleration in growth for agricultural derivatives.
CME’s precious metals division (COMEX) is primarily driven by Gold although Silver and Copper are also meaningful contributors. This is a strong growth area for CME to continue to take share, benefitting from structural tailwinds. COMEX has generated 11.5% volume growth for CME since 2010, above the industry precious metal derivatives trading growth rate of 9.9%. Notably, this growth is strongest in its largest products (Gold and Silver) which have both strongly accelerated in the past 5 years. This strong growth has been partially offset by a declining RPC of 2.2% per annum which is driven by the mix shift associated with ‘micro’ futures becoming a greater part of CME’s portfolio since their launch in 2011. I.e. this is not a reflection of pricing pressure in CME’s core metals products.
In order to understand the drivers of CME’s Gold volumes which account for 2/3 of COMEX’s volumes, we need to understand the market for gold trading. The three most important gold trading centres are the London OTC market, the US futures market and the Shanghai Gold Exchange (SGE). These markets comprise more than 90% of global trading volumes and are complemented by smaller secondary market centers around the world (both OTC and exchange-traded). The London OTC market is a classic example of how strong a marketplace network effect can be, accounting for 70% of gold trading for legacy reasons.
Notwithstanding the London market’s pre-eminence, it has been losing relative share of global trading volumes. In 2015 banks operating in the market stopped submitting forward offered rates (GOFO rates) which were used to establish the market’s forward curve, one of several symptoms of a market that has become increasingly fragmented. COMEX has been rapidly taking share due to the convenience of futures contracts which enable broader market participation for parties that do not wish to bear the cost associated with physical delivery of the precious metal.
- Exchange-traded futures’ standardized terms make buying and selling positions easier
- All market participants see the same transparent prices, not just the other counterparty
- Futures offer substantially mitigated counterparty credit risk, with payment backed by the exchange
- You can easily offset your futures position in a centralized, electronic market — unlike non-transferrable positions of forwards
- Futures are regulated by CFTC oversight; trade settlement of forwards is dependent on counterpart
Futures also possess several attractive features relative to ETFs and OTC forwards outlined below. Benefits of Gold futures vs. ETFs include:
- Trades equivalent of 27 million ounces/day – 30x SPDR Gold ETF at 0.8 million ounces/day
- With GC futures, pay no management fees vs. an ETF that charges a fee on your position every day it’s held
- GC futures have standardized physical delivery terms; redeeming ETF holdings for physical gold can be complex and restricted to certain investors
- If looking to trade on margin, initial margin can be as low as 3% of contract value, versus 50%+ margin for ETF, plus any broker financing fees
Clearly futures offer significant advantages relative to other methods of achieving gold exposure. COMEX has the highest traded volumes of Gold futures (Code GC) among all the global exchanges, at over 381,000 contracts (or 1,185,000 kilograms) a day. The gold market trades around the clock and CME Group offers trading virtually 24 hours per day enabling the world to access the market at times that work best for their schedules whether they are in Asia, Europe, Latin America or the United States. For example, the volume of GC traded during Asia trading hours alone is over 390,000 kilograms a day. The figure below shows that COMEX gold volumes, during Asian hours alone, are greater than the total volumes of the individual peers in Asia which are the largest competitors from a futures perspective.
Many of the same benefits outlined for Gold are applicable for Silver although CME’s level of market share is not quite as high, it still benefits from the deepest pools of liquidity.
As a result of these structural tailwinds, I forecast volumes to grow at the five year CAGR of 14.7% and rate per contract to decline 2.2% annually. The five-year period chosen reflects the time since the London OTC market began to lose share, and where the market structurally begun to shift away from OTC gold forwards. The spike in Gold and Silver futures is underpinned by the significant rise in Swap Dealers and Money Managers activity as CME benefits from the structural acceptance of Futures amongst speculators.
There is a significant runway available for future growth given CME’s low current market share and the structural tailwinds discussed. Additionally, demand for gold is elevated currently – and likely for a numbers of years – due to QE and fears of currency debasement, leading to increased levels of speculative market participation. Note that Gold is the largest segment within CME’s metals division and has grown volumes 17.2% on average over the past five years – above my forecasted growth rate and this is before taking into account any increased speculative activity arising from the most recent round of QE. This accounts for ~7% of revenues for CME however, due to the structural tailwinds discussed, I forecast the segment to reach 15% of Futures and options revenues by 2030.
Equities is currently the second most important category by share of revenue although this is likely to change over the coming decade. CME primarily offers S&P, Nasdaq 100 and Russell 2000 E mini futures and options. ICE combines Interest Rates and Equity index futures into one category so it is difficult to get an exact reflection of share however, CME holds >85% share vs. ICE across Financials (Rates, Equities, FX) when measured by revenue. On balance, Equities are one of the more competitive asset classes for futures exchanges globally as there are many ways for participants to express a trading view.
Taking a close look at the trends for CME, it would appear from the below figure that equity index pricing has softened however, a closer breakdown of recent RPC (rate per contract) shows that this is a misnomer.
Pricing has actually remained relatively consistent over the decade excluding the past year. This is due to the launch of a new ‘micro’ E mini contract in May 2019 which has been deflationary for RPC but accretive to revenue. The net effect of this has been stronger revenues vs. pcp so the new contracts have been positive for the group despite optically softer pricing. The graph above highlights how stable equity index RPCs have remained from 2007 to 2017. The table below demonstrates the weaker pricing which commenced in 2Q2017, coinciding with the shift in contract mix. Equities remain a stable source of revenue although volumes growth has remained relatively lackluster in the last decade – annualizing 1.6%. It is a competitive market with multitudes of ETF’s to put index exposure on which has likely contributed to meager growth.
The volume picture in indices is less variable due to macro factors than the rates complex and as such acts as an effective hedge. There has been consistent growth from asset managers (red in the below chart) in the equity index portfolio suite as fund managers become more accustomed to slightly more exotic methods of managing risk and portfolio exposures. This is due to the capital efficiency associated with using futures to alter portfolio beta. Asset managers can dramatically alter portfolio exposure without the transaction costs associated with moving into/out of single stock positions. Equity markets do not experience the same volatility declines associated with QE that Rates do and one could even argue that equity volatility increases with rates at the ELB, structurally increased retail participation associated with commission free trading in the US and the increased sophistication of the asset management industry. In other words, the two segments are at times negatively correlated.
There have been limitations to the Equity futures growth story though as demonstrated by the volume growth in the past 10 years. There are many ways to get exposure to the S&P 500 in a low cost, capital efficiency and liquid way that does not require the use of futures or options. Alternate exchanges offer similar products and the rise of ETFs has led to a number of competing products. As such, I forecast 1.7% volume growth to continue to persist. The forecasts for equity indices volume / revenue growth are challenging as the introduction of micro contracts limits the past’s usefulness as a guide for aggregate volumes/ rate per contract. Regardless of the relative drivers between price/volume, I forecast a 1.1% revenue CAGR from FY21 to FY30 which I believe is sufficiently conservative and if anything, slightly below the historical track record.
Energy is the most competitive segment between ICE and CME. CME operates the primary exchange for trading futures of WTI while ICE is the primary location for Brent trading although it is worth noting that both players have a wide range of products that can be traded. CME splits the broad Energy futures market with ICE from a revenue standpoint 45%/55%. Volume growth has been relatively strong across the Energy complex, averaging 4.8% over the past decade although pricing has decreased at a compound annual growth rate of 3.65%, largely offsetting these volume gains.
Part of the problem is that market participants will favour a localized exchange to hedge oil and gas, capping the market share CME can gain from globalization. There is no strong incentive for market participants in different countries to switch over to CME unless induced by pricing as many oil and gas benchmarks are already well established with sufficient liquidity pools. Additionally, many users can achieve the same exposure from trading ICE Brent or CME’s WTI products, limiting pricing power. CME holds ~80% market share in Henry Hub trading amongst other refined products however, this is a small component of the overall Energy mix. CME revenues earned from this segment have somewhat stagnant over the last decade – only reaching new highs for the first time as a result of the 1Q20 volatility driven by the Russia/Saudi oil price war.
The benefit of this asset class being within the CME portfolio is a degree of diversification away from other products. Movement in Energy prices is extremely volatile and uncorrelated to interest rate movements, demand for commodities or financial market volatility, which provides a degree of support during unfavorable conditions in other categories such as what we are presently experiencing in Rates with QE. As a result of these competitive dynamics, I forecast revenue to grow with a 0.93% CAGR over the forecast period as modest volume growth is largely offset by pricing pressure.
Foreign Exchange is the smallest asset class within CME’s futures segment, despite having grown volumes by an average of 3.3% over the past decade. The segment for <5% of revenues for CME and is not a major driver. The FX markets is so liquid that the inherent benefits offered by futures are less meaningful as participants can benefit from the greater flexibility offered by OTC derivatives, without suffering from slippage costs associated with reduced liquidity. CME still dominates certain futures contracts, exhibiting a strong network effect although, I do not forecast significant growth to come from this asset class.
CME acquired EBS as part of NEX group which does provide cash exposure however, the market has become extremely fragmented over the past decade leading to significant losses in market share in the cash market. It has since stabilized and EBS remains the premier source of liquidity in cash FX markets among certain cross rates however, the day to day need for the majority of volumes to go through the EBS platform has been diluted by major banks and other market participants offering relatively frictionless trading. It still remains relevant for larger players requiring deeply liquid cash markets however, it is hard to see significant growth occurring from this business.
CME: Forecasts and valuation
Revenue – CME’s historical transaction growth is volatile which makes extrapolating a trend to forecast revenue growth difficult in the short term. However, longer term trends within asset classes have remained relatively consistent over the past decade. As a recap of the above section, the average daily revenues & forecasted growth rates can be found below. Additionally, I forecast total cash transaction revenue to grow at 1%. This is below historical growth rates however, the historical dataset is limited and it is uncertain how cross selling volumes will evolve over time. As such, I have chosen to remain conservative in my forecasts, waiting for more results to pass before I can assess the NEX group acquisition with more bullish assumptions.
The annualised revenue growth over the past decade in Futures clearing and transaction fees is ~5% and I forecast slightly slower growth over the decade to come (4.6%) despite a positive mix effect as asset classes with structural tailwinds to volumes become a larger weight in the CME portfolio. I have forecast ‘Market data and information services’ and ‘Other revenue’ to grow at 1.6% and 2.5% respectively. Other revenue comprises primarily of access and communication fees for telecommunication services, optimization services and post trade services. This segment has historically grown above my forecasted trend but again, I seek to leave a margin of safety in non-core segments. The below table details my assumptions and the changes in futures earnings mix.
Expenses – The expenditure requirements for CME are largely fixed, providing a solid platform to generate significant operating leverage over the coming decade. As per CME’s 2019 annual report…
“The majority of CME’s expenses do not vary directly with changes in our contract volume. However, licensing and other fee agreements can vary directly with certain equity, energy and swap volumes as well as the majority of our employee bonuses vary directly with overall contract volume.”
CME has generated volatile but significant underlying margin expansion over the past decade as volumes have grown. The dip in EBIT margin occurring during 2012/2013 was attributable to a drop in volumes in its core interest rate product. In fact, CME grew its cost base by just 1.5% from FY11 to FY13, effectively managing the expenses to mitigate the impact of a fall in volumes. This operating leverage works both ways however, provides a strong foundation for significant margin expansion over the coming decade as volumes rise. The recent drop in EBIT margins can be attributed to the NEX acquisition, whereby $500mn revenue was added to the group at a 24% operating profit margin vs. CME core margins >60%. Over time, CME has identified $200mn in synergies and does not see any reason why the cash business cannot trade at similar margins to the group. The slow recovery in my forecasts is compounded by operating de-leverage associated with reduced volumes in the Rates complex although, I believe this margin expansion to be conservative – particularly when using the FY14-FY17 post QE expansion in margins as a guide.
CME generated 470bps of margin expansion from 2013 to 2018 as the below table demonstrates. The fixed cost structure is most evident in CME’s 1Q20 result where CME grew margins 1000bps vs. 1Q19 as a result of record interest rate volatility driving significant volume growth. This highlights the operating leverage inherent in the business model and demonstrates the scope for CME to continue to expand margins. The major cash operating expenses are:
- Employee compensation (~50% of opex) – More volumes going through the marketplace do not require any additional human resources (although the end of period expense may appear higher as staff remuneration is heavily linked to volume performance of the group.) After assuming ~$100mn of cost out post NEX group synergies, I forecast this line item to grow at 2.5% – in line with the prior decade.
- Technology and support services (~7% of opex) – this has remained relatively constant at ~2% of sales for the past decade although has recently risen to 4% on the back of the NEX Group acquisition. I forecast this to return to that 2% of sales level by 2030 as costs associated with the NEX business are streamlined and integrated
- Professional fees and outside services (~10% of opex) – I forecast this to grow at 3.5%, in line with the prior decade average.
- Licensing and other fee agreements (~10% of opex) – I forecast this to grow as a % of revenues derived from Equity index products (which has averaged 27% of Equity revenues over the past 3 years.)
- Other (23% of opex) – I forecast this to grow in line with revenues as 7.6% of sales although in reality, these costs are unlikely to all grow proportionally to revenue and I believe this to be a conservative estimate.
It is apparent from observing a common income statement that at least ~67% of expenses are uncorrelated with volumes in a meaningful way and instead, tend to grow with inflation and/or new business initiatives. The nature of CME’s expense base and management track record underpins EBIT margin growth assumptions in my DCF over the next decade.
CME benefits from its structure as a capital light earnings compounder which ensures the business can grow without requiring significant free cashflow to be reinvested back into the business. CME generates a ROIC greater than 30% however, this assumes a capital base including amortizeable intangible assets arising from past acquisitions. Return on tangible capital tends to be in excess of 90% although varies by year.
Working Capital – The major working capital items are a/c rec and a/c payable although they are not significant given CME’s marketplace business model. As a result, working capital as a percentage of sales has averaged 0.7% over the past 5 years and as such, does not meaningfully detract from free cashflow in my forecasts.
Capital Expenditure – The capital expenditure profile is similar, with minimal additional capital required to run the business as volumes grow. There is some upkeep required for PPE assets and software however, this works out to be ~2% of sales. As a capital light compounder, CME will continue to generate significant free cashflow from its asset base well into the future and will be able to distribute these free cashflows to shareholders in the form of dividends.
CME is currently in the midst of integrating the NEX acquisition and as a result, future capital expenditures for technology are anticipated. CME continue to support their growth through increased system capacity, performance improvements, integration of acquired platforms as well as improvements to some of their office spaces. As a result, capex will likely be slightly elevated however, will return to a lower level in the near future. Each year, maintenance capital expenditures are incurred for improvements to and expansion of their offices, remote data centers, telecommunications network and other operating equipment although these are relatively minor.
In 2020, capex is forecast to be within the range of $180-$200mn although is likely to step down in future years, closer to the $100mn mark it has historically been. My forecasts assume capex of $160mn per year although I believe this to be conservative when considering that total capex from 2015-2017 (prior to the NEX acquisition) averaged below $100mn.
Integrating these assumptions into a DCF leads to and enterprise value of $70.03bn under the follow assumptions. A terminal growth assumption of 3.5% is above what I would usually forecast, however, CME’s strong competitive advantages and lean operating structure provides confidence that the business can continue to grow slightly above inflation/GDP as incremental topline growth benefits from considerable operating leverage. It is worth noting that my terminal FCF multiple of 20.4 is below normal historical averages and in accordance with the premium I assign for what is effectively an unregulated monopoly.
CME is currently trading below its five-year average when assessed on a pe multiple. It is worth noting that next year’s earnings base is constrained by the slowdown in interest rate volatility, making CME appear more expensive than it otherwise might in a more normalized year. Regardless, 24x is a slight premium to the SPX industrials ex materials and financials (trading at 21.7x) in the current climate which is an attractive multiple for a stock with structural growth tailwinds, a non-regulated monopolistic market structure and a capital light operating model.
Integrating the above forecasts into my model, I forecast average NPAT growth of 6% over the next decade. I believe there are a number of conservative estimates including the time taken to return to a normal interest rate volume environment (FY25) and the prospects for future margin expansion. Despite this, CME offers attractive earnings growth of 6% complemented by a 3.8% dividend yield.
Terrence Duffy has served as Chairman and Chief Executive Officer since November 2016. Duffy previously served as our Executive Chairman and President since 2012 and as Executive Chairman from 2006. He has been a member of the board of directors since 1995. He also served as President of TDA Trading, Inc. from 1981 to 2002 and has been a member of our CME exchange since 1981. Terrence has a lifetime of experience in futures exchanges and has been on the CME board in excess of 25 years. He is a highly qualified subject matter expert and more importantly, understands the business extremely well after a multi decade affiliation with CME. There are a number of aspects worth touching on when assessing the management team.
1) Excellent track record of market messaging
CME solely provides expense guidance, guided by the belief that futures volumes are largely unknowable and dependent on macro conditions. The below table demonstrates that over the past
decade, CME has routinely hit guidance in all but one of the previous 9 years, a testament to management’s disciplined approach to costs and meticulous strategic planning. This also reinforces the scalability of the current capital base and cost profile. One of the few variable expenses (employee incentives) is heavily predicated on performance and aligns the businesses employees with shareholders strongly.
|2020||Management provided its core operating expense guidance for 2020 of $1.64bn – $1.65bn. This contrasts with Street’s estimates of $1.65bn.||Management have since lowered its core operating expense guidance for 2020 to approximately $1.595bn|
|2019||CME provided 2019 core operating expense guidance of $1.65bn to $1.66bn||Management delivered core operating costs of $1.637.2bn|
|2018||Management guided operating expense (ex licensing fees) of $1.1bn – $1.105bn||Complicated by acquisition of NEX group|
|2017||– Expenses: CME expects operating expense (ex license fees) to be up about 1% to $1.09 billion||Management delivered core operating costs of $1.073bn and $82mn capex in 2017. Regulatory pressures on exchange market data affected the broader industry and resulted in CME failing to meet Market Data guidance|
|– Market Data: CME expects ~5-6% market data revenue growth over the next few years, with 2017 being back-end loaded.|
|2016||Operating expense, net of licensing and other fees (volume sensitive), is expected to be $1.185bn, implying 1% y/y growth.||Management delivered core operating costs of $1.080bn|
|2015||Expense guidance for 2015 is flat at $1.31 billion.||Total expenses were down -0.4%|
|2014||We expect operating expenses to come in at approximately $1.31 billion, up less than 3 percent from the adjusted 2013 expense, or up 5 percent when you exclude the cyber incident and deferred compensation.||Total expenses were up 3.4% although came in below the guided 3% when one offs are excluded (e.g. compensation arising from a strong operating year )|
|2013||For 2013, we expect approximately $1.25 billion of expenses for the year based on our assumption of top line growth. In addition to normal inflation, there are three primary areas to point to including bonus expense, investment in growth initiatives leading to higher staffing and a new marketing campaign. In 2013, as we do every year, we are resetting our bonus estimate to the target level of approximately $68 million.||Total expenses came in at $1.29bn or >4% higher than expected|
|2012||If ADV growth were to come in close to 10 percent, we would expect expense growth to be in a range of 4 to 5 percent, and if volume were up between 0 and 3 percent, we would expect expense growth of 2 to 3 percent. In 2012, we expect our non-compensation expenses to be basically flat compared to 2011, with the main wildcard being our license fees.||Total expenses finished lower in 2012 vs. 2011 despite guiding to expense growth. This decline was driven by amortization of purchased intangibles|
|2011||In terms of 2011, we expect total expenses to increase to approximately $1.26 billion, assuming our target bonus payout, up from the $1.17 billion last year, which includes the $20.5 million impairment we booked in Q2 2010..||Total expenses were $1.26bn for FY11 which was exactly in line with guidance.|
2) Capital allocation track record
Unlike other exchanges, CME has stuck firmly within its core competency. All acquisitions in the history of the company have led to additional futures capability or, in the case of the 2018 NEX group acquisition, an adjacent cash market exchange business. CME’s assets are listed below:
- Chicago Mercantile Exchange (original business)
- Chicago Board of Trade (agricultural commodities exchange)
- New York Mercantile Exchange
- Commodity Exchange. I.e. COMEX (Metals)
- NEX Group (Cash US Govt. bonds and FX)
All of these acquisitions have generated significant cost synergies and led to meaningful revenue growth for the parent company. CME paid $8bn for CBOT and $8.9bn for NYMEX prior to the GFC while the broader group generated $2.5bn in EBIT in 2019. Both assets continue to meaningfully grow volumes some ten years later. The strong moat surrounding these capital light assets ensures that CME will benefit from many more years of cashflow generation as the no. 1 Futures exchange globally, vindicating past acquisitions.
3) Incentive Structures
Terrence Duffy received >50% of his annual remuneration as stock which aligns him with shareholder friendly outcomes. His bonus remuneration has historically been predicated on achieving TSR and net income margin growth although next year will integrate cost out targets related to the NEX transaction. These incentive arrangements demonstrate CME’s firm focus on cost control and driving shareholder value creation by attracting volumes to the marketplace. It is certainly a risk that Terrence has persistently sold portions of his equity based compensation however, his long tenure with the company and terrific growth track record somewhat offsets the negative signalling. Although a lack of insider ownership is not ideal, CME’s outstanding performance over the years demonstrates that Terrence views his share sales as prudent personal wealth management, rather than revealing a potential red flag of short term management decision making.
CME has grown high levels of market share across a number of its key asset classes in the past decade, translating to pricing power and strong network effects as a consequence of offering the deepest pools of liquidity. The implicit cost market participants must pay when crossing wider bid-ask spreads affords CME a degree of pricing power however more importantly, creates a moat that is uneconomical and extremely difficult for a new entrant to cross. Structural volume growth on a largely fixed cost base has led to CME’s extraordinary margins. The low levels of capital intensity (2% of sales) promote high levels of free cash flow that can be distributed to shareholders in the form of dividends.
Trading at 24x, CME is slightly below recent averages on an earnings base that will be depressed due to a lack of interest rate volatility. This affords a margin of safety from a valuation standpoint however, the most compelling rationale for buying the stock is its business structure – a capital light, non regulated quasi monopoly with high barriers to entry. CME is excellently poised to continue generating considerable cashflows for shareholders.