CME Group: Poised To Benefit From Rate Cuts; Continues To Innovate

Markets may rise or markets may fall, but one certainty is the existence of markets themselves, and by extension market operators/exchanges. Taking a cut from market action, regardless of the direction, is an enviable business to be in. I’ve always drawn similarities between this industry and airport operators. Both serve as a host, or hub; they provide the infrastructure for where business takes place, without being directly involved in the economics of that business. – (Shopify (SHOP) would be a new economy example of that type of business. The company depends on consumer confidence and needs a growing volume of viable vendors, but isn’t directly exposed to the profitability of the transactions.)

The other thing that financial market operators and airports have in common is that they are hard to replace, or circumvent. These are businesses that Michael Porter would love. As a refresher for those whose academia days are long past, here’s a reminder of Porter’s 5 forces:

• Level of Competition
• Threat of New Entrants
• Bargaining Power of Suppliers
• Bargaining Power of Customers
• The Risk of Substitutes

Some might describe financial market operators and airports as having a lot of monopolistic power, but both industries tend to be highly regulated. I’d prefer to describe these as ‘toll businesses’ that are highly defendable.

Investing in ‘toll’ businesses is not risk-free. There always remains the risk that business volumes move elsewhere. While there are concerns circulating about competition for CME Group (NASDAQ:CME), I don’t see the business as being in danger. I picked up shares of CME in a recent dip below $200 and am a happy holder of the stock.

CME Group Background

Until 2007, the company used to be called the Chicago Mercantile Exchange, until it merged with the Chicago Board of Trade. Remaining in Chicago, CME Group currently operates exchanges primarily for derivatives in the following assets classes:

• interest rates
• agriculture
• energy
• metals
• forex
• equity index

Just to emphasize, CME facilitates the trading in derivatives, mainly futures and options, for the above asset classes. The CME is not where a trader would go to perform a basic forex transaction or equity index purchase.

While derivatives markets are gigantic, participation in them isn’t mainstream. Derivatives products also have a muddy history, with Lehman Brothers, Enron, Long-Term Capital Management – all companies that imploded – having all suffered the brunt of being on the wrong side of huge derivative exposures.

That doesn’t mean derivatives are dangerous by nature; just that they need to be handled with caution and regular monitoring by those who take on exposures.

As for CME Group itself, its results and stock price took a hit during the financial crisis, but in my understanding that was mostly due to liquidity drying up, resulting in reduced market participation in the derivatives functions it offered. Results quickly rebounded as people regained confidence in the economy.

Many people still associate derivatives with speculation, and while a great deal of speculation does occur, the historical foundation of derivatives is anchored on risk management / risk hedging. Dr. Ernst Juerg Weber of the University of Western Australia found that the use of derivatives probably goes back half a millennium or more. My own career experience revealed to me the incredible importance that derivative instruments offer participants in the world of agriculture.

CME Group Financials

The bulk of revenues (~$5.4 billion TTM) generated by CME Group come from transaction and clearing fees. These activities drive more than 80% of the company’s top line. The provision of market data to market participants is a secondary driver of revenues.

Since the company’s product is essentially its platform, costs are very low. CME Group realizes operating income margin in the ~60% range, and in fact this number has been improving in recent years after a dip during the pandemic period.

That obviously leads to a very high Price-to-Sales ratio, with CME’s P/S standing at about 13.4x, even higher than most peers.

On the flip side, CME Group is more efficient at translating sales into profits. One reason for this is the company’s more conservative capital structure. Companies like the London Stock Exchange (OTCPK:LNSTY) and the Intercontinental Exchange (ICE), which owns the New York Stock Exchange, have seen rising debt costs eat a higher share of their operating profits in recent years. The other key driver is much lower SG&A costs for CME Group.

Notably, CME Group has continued to drive operational efficiencies over the past few years. The company has also been delivering an impressive EPS growth trend.

Recent Results

CME Group reported Q2 GAAP EPS of $2.42 on July 24, which beat expectations by a penny, on revenue of $1.53 billion. The top line rose by an impressive 12.7% year-over-year.

The company converts most of its earnings to cash, and annual capex of under <$100 million is almost negligible compared to the ~$3.5 billion of annual CFO they’ve generated recently. With very little debt on the balance sheet, CME has raised its (regular) dividend in each of the past 11 years, if not longer. The company tends to pay a quarterly dividend (currently $1.15) supplemented by a special end-of-year dividend. In recent years the special year-end dividends have exceeded the aggregate regular dividends paid during the same year. If that’s the case again for 2024, this could be the first time CME pays more than $10.00 in total annual dividends, although there’s not much flexibility in the payout ratio (which stands at slightly above 100%).

The total yield is quite healthy in the 4.6% range. The regular-only dividend yield is about 2.15%.

Prospects and Outlook

Interest rate derivatives represent the highest volume trading segment for CME Group. As investors will know, the Fed Funds Rate has been held at its current 5.25% – 5.50% level for more than a year now. We also know that this is set to change, with a high certainty of a rate cut here in September.

While there’s quite a bit of consensus for near-term rate cuts, there’s a lot of dispersion in expectations for once 2025 is set to arrive. The FOMC’s Fed Funds Rate dot plot evidences this.

Such dispersion is likely to benefit CME’s results for the foreseeable future, as the company has pointed to a highly correlated relationship with interest rate trading volumes.

This is also a company that continues to innovate and deliver new trading product options to market participants. In my view that’s very important, as the small chance of a company like CME getting displaced can rise if they are sitting on their laurels, failing to adapt to trader demand.

Wall Street Analysts are projecting full-year 2024 Non-GAAP EPS of $9.91; a level which the company could beat considering the $5.06 in Non-GAAP EPS they’ve delivered during the first half of the year. GAAP EPS tends to come in about 6% lower, and I could see it potentially reaching $9.50 once 2024 is said and done, especially if interest rate derivative trading picks up during the last few months of the year.

On that basis, CME appears to be trading for a GAAP P/E of about 22.7x, which looks competitive against an S&P 500 multiple of ~26x.

I expect CME’s attractive dividend to appeal to investors as interest rates start to move down. I also believe CME’s shares would perform well in any new period of market turmoil, which could be on the horizon as we approach the U.S. general election, not to mention the geopolitical risks out there.

I thus rate CME Group a Buy. I’m a patient owner here, and appreciate the diversification the stock offers my portfolio. I’d happily offer CME a 25x GAAP P/E ratio, for a target price of $237.50.

Risks

• One major risk scenario for CME Group is an extended liquidity crisis environment. In such an environment, investors are more likely to reduce their derivatives holdings and shy away from new positions. That could cause a trading volume slump over an intermediate term.
• A greater unknown might be the eventual success, if any, of BGC Group’s (BGC) competing FMX Futures platform, which is set to launch this month. The top of this article referenced Porter’s Five Forces, and a new entrant into CME Group’s space may be a danger. However, I’m doubtful about the ability of this new entrant to develop a significant amount of clout to challenge CME’s business, at least in the near term. There’s a lot of value at risk in dealing with large volumes of derivatives contracts, and I expect most market participants to shy away from an unproven new platform that could potentially save on fees.
• If CEO Terrence Duffy and his management team start to feel heat from competitive threats, they might ramp up spending to combat those threats, offer discounted pricing, or both, which could put pressure on CME’s delightful margins.