The CME Group owns and manages four of the biggest global stock exchanges: the Chicago Mercantile Exchange (CME), the Board of Trade of the City of Chicago (CBOT), the New York Mercantile Exchange (NYMEX) and the Commodity Exchange (COMEX).
The group is active since the end of the 19th century and offers investors an unparalleled offering of derivative products (futures, options, etc.) that allow them to cover themselves against monetary risks and the price fluctuations of commodities (energy, metals, agricultural commodities, etc.).
The trade boom of these derivative products goes well beyond a simple speculative fever: in a complex and volatile globalised economy, companies (producers as well as their clients), banks (central or private) and investment funds all have a strategic interest to cover (hedge) their purchase or sales prices, often contractualized for several years.
For example, an oil producer who fears that the price of the barrel will tumble again can choose to ‘lock in’ his future selling price at a rate that allows him to amortize his production costs - let’s say $70 per barrel - thanks to a combination of futures. Naturally, this kind of insurance has its price, one that will increase as the barrel price goes down, and vice-versa.
Along the same lines, a multinational that borrows in local currency to finance its expansion in new geographies will have to cover itself against the exchange risk or a brutal ascent of the interest rates. For several years, we clearly observe how these currency effects dramatically impact the consolidated profits of big companies - there is thus a lot at stake.
While the London exchange once competed with Chicago (CME and CBOT) and New York (NYMEX and COMEX), the scale finally tipped in favor of the American side following the merger of these two big players. Neither the Chinese nor the Europeans are at the moment capable of competing.
The long-term tendencies are remarkably positive, partially thanks to the progressive integration of Asian and Latin American economic players into the global financial system. As long as the dollar remains the reference currency of the international exchanges, the markets and instruments managed by the CME will be unavoidable.
By the way, thanks to its unique scale in the world, the group is the only one able to propose unit transaction prices that are this low, on a trustworthy and (ultra) regulated stock exchange where the liquidity is excellent. All these criteria are crucial in the choice of investors and they are what gives the CME its extraordinary competitive advance, one that seems to be difficult - if not impossible - to dispute.
This success of this competitive advantage (the famous ‘moat’, dear to Warren Buffett) is reflected in the company’s accounts, particularly in the extraordinary margin profile - over 60% of operating margin! The group generated around $2,5 billion of pre-tax profit in 2017, for $3,6 billion of turnover.
(Please note though: the net result in 2017 is inflated by a very favorable fiscal adjustment of $1,5 billion, punctual by nature).
The financial position of CME is excellent, with a short-term financing directly indexed to the trading activity and a long-term financing that is very stable: $22,4 billion of equity, for just $2,2 billion of debt. We appreciate that the group auto financed its expansion (they earn enough to afford this) without issuing new shares or degrading their balance-sheet.
In terms of valuation, the market capitalization of $57 billion involves a multiple of 223 times the previous pre-tax result, or gross modo 30 times the result after tax - in this market, that’s a fairly typical valuation for a mature company of this kind of quality.
Analysts project a sustainable profit growth until 2019, mainly thanks to the recent acquisition of the NEX group, who is very present on the currency market and in short-term bank financing activities. It’s interesting to see that CME has paid £3,9 billion to acquire NEX and its £100 million of annual profits (normalized over the past five years), a multiple of 39 times the profit of the latter.
Given its critical size, the CME Group is now in a position to consolidate rather than being bought by a third-party - especially since mega-mergers in the exchange industry are often dismissed by the regulator under anti-trust laws.
This is why the creation of future value will largely depend on the quality of the acquisitions made to enrich the services -and financial instruments offering, and of course on the increase of the dividend - the natural alternative if CME doesn’t find anything to its taste among the acquisition targets.
Translated from the original article.
Article published on 06/20/2018 | 15:36