- Shares down almost a quarter in 2022
- Exchange business has wide moats
- Trading activity has grown strongly
It’s been a tough year for CME (US:CME) shares despite some impressive financial performance. With the shares down by almost a quarter in 2022, could this present an opportunity for investors seeking access to a formidable powerhouse in the trading of futures, options, cash and over-the-counter (OTC) products?
Two aspects suggest CME will be well-placed to weather a recession and benefit from the next cycle. First, the business is to a large extent naturally insulated from recession as this usually leads to more trading and more volatility. Just check out 2020. Second, it offers continued product innovation and a wide moat built from some of the most important and dominant exchanges and OTC markets, notably the most traded futures and related options contracts.
Talk about a moat? The business includes the Chicago Mercantile Exchange (CME), Board of Trade of the City of Chicago (CBOT), New York Mercantile Exchange (NYMEX), the Commodity Exchange (COMEX) as well as its cash markets business, central clearing houses and other divisions. Operating various futures exchanges has been its strong suit, but there is growing excitement among clients about its integration of the Electronic Broking Services (EBS) FX platform from NEX, which enables CME to go toe-to-toe, or even beat, Refinitiv in forex trading.
All told, it is the dominant and largest derivatives exchange in the US. Notably, in this year of great bond market turmoil, it is the place for companies to manage interest rate risks, which have suddenly come to the fore. CME’s moat stems from its scale, which means better liquidity and pricing and a wider range of assets and derivatives to trade, which begets more growth and the ability to add new products.
Recession resilience? Volatility in financial markets tends to be positive for CME. The doubt would be if the Fed decided to cut rates back to zero, a situation that is surely a very long way off. Rates uncertainty is likely to persist for years as we enter a new macro dynamic.
Valuation concern? This would be a reasonable concern. CME is trading at about 23 times earnings, which is ahead of peers. Meanwhile, earnings per share (EPS) are expected to grow at 2.4 per cent a year for each of the next three years, versus over 9 per cent for peers.
Recent results have been encouraging, though, and suggest the valuation might be justified with about 50 per cent earnings growth in the past year. Volumes are soaring across different components of the business. For instance, at the equity index business, the first three quarters of this year were the first, second and third highest quarters on record for average daily volumes (ADV); the same for equity index options.
In the year to date to the third quarter (Q3), total ADV has increased 44 per cent and options ADV has increased 74 per cent compared with the same time frame last year. “It is important to note that our growth is driven not only by volatility, but also by product innovation,” notes Tim McCourt, global head of Equity and FX Products.
For instance, one of the most successful innovations was the launch of Micro E-mini products (smaller size futures products) in 2019. “We view the micros as a useful tool to continue to attract new international and US-based customers, given the smaller contract size and the lower upfront financial commitment,” says McCourt.
Due to the premium pricing on these, versus standard equity rates, the $3.2mn micro equity contracts that trade per day are equivalent in revenue terms to approximately $1mn E-mini contracts (E-mini contracts are themselves a previous generation innovation that made futures trading affordable for investors outside the big institutions), despite being one-10th the notional size. In all, premium products such as these S&P 500 futures contracts and the rather more niche adjusted interest rate total return futures, sector futures and dividend futures command fees of three to four times that of standard equity rates.
Interest rates, equities and FX products have hit peak levels of large open interest holders with interest rate products at an all-time high. Additionally, Q3 represented the fifth sequential quarter of double-digit year-on-year total ADV growth. FX has “come alive” and ADV in this segment rose 41 per cent.
Fixed-income trading remains positive too. Interest rate futures and options ADV were up 28 per cent in Q3. CME has now posted six consecutive double-digit year-on-year ADV growth quarters for the asset class. And tailwinds ought to continue.
“Every FOMC [the Federal Reserve’s open markets committee that sets US target interest rates] meeting is in play and with high and uncertain inflation, every jobs report and every consumer price index (CPI) reading is important. You could see this very clearly with the 34mn contracts trading on a single day on 13 October, following the CPI release, and the uncertainty here could remain for years as inflation ratings for rent and shelter tend to lag the real economy by up to 18 months,” Sean Tully, global head of rates and OTC products, noted on the last earnings call.
In total, Q3 reported revenue of $1.2bn (£1.0bn) and operating income of $739mn for the third quarter of 2022 was driven by 26 per cent growth in overall trading activity.
As of the end of the last quarter, the company had around $2.2bn in cash and $3.4bn of debt. The company paid dividends during the third quarter of approximately $363mn. Shareholder returns are based on ongoing strong cash generation and a relatively low capital expenditure requirement. The company has returned over $18.8bn to shareholders in the form of dividends since the implementation of the variable dividend policy in early 2012. Capex in the third quarter was just $20mn.
Deutsche Bank analyst Brian Bedell recently upgraded CME to Buy from Hold, after the stock's approximately 33 per cent decline from its 52-week high in March suggested there is now a more positive risk-reward equation.
Given a roughly 5 per cent dividend yield "we view the stock as offering excellent value with a solid income stream, which may easily become more attractive should a challenging market and macro backdrop persist for some time," Bedell said in a note to clients. He also thinks there is a "modestly better” volume outlook for CME.
With relatively low capex required to generate free cash flow growth and consistently high dividends, and a relatively secure position as the premier derivatives market in the US, CME looks well-positioned, but valuation might still be a concern.
More of Neil Wilson's US shares analysis is featured in Investors' Chronicle Alpha. The service also regularly screens the S&P 500 for US shares that stand out for quality, reasonably priced growth characteristics and earnings upgrade momentum.
