The Chicago Mercantile Exchange (NYSE: “CME”) facilitates the purchase and sale of futures and options contracts across a range of categories. The products that trade on its platforms include commodities, interest rates, equities and metals among others. With a market cap of ~$18B, it generates close to USD $3B in revenue annually across its business units at gross margins approaching 75%, with net income of nearly $1.5B annually.
So what are futures contracts and what benefit do they bring? For traders, these products allow the future price on a metal, agricultural commodity or interest rate to be locked in today.
This can be valuable for a trader. In the case of a crop harvest, crop sales may only occur 6 months into the future. A farmer may not wish to take exposure to changes in price between now and then. The CME crop futures allows the farmer to lock in their price today and not be exposed to changes in price over the 6 months till the harvest is completed.
The business model of a futures exchange is fairly simple. It makes a certain revenue based on each futures contract that is originated and settled on the exchange. What this means is that the more futures contracts that the CME can have traded on the exchange the more money it makes.
The CME charges traders a commission based on the size of the trade that they execute with the exchange and the nature of the contract. While other exchanges may offer competitive products to CME, traders are most interested in trading on the exchange where the greatest volume of trades in a given product or commodity occur.
Why is this? It’s because traders want depth of price discovery. What this means is that the more contracts that are traded and the more volume that exists, the higher likelihood that you’ll be able to get a price match closest to the price and the volume you want to trade. Even a single cent difference can mean a big impact in terms of the profitability of the trade.
What this leads to is the creation of natural monopolies that favor the player with the highest existing market share. A higher market share in a certain futures product leads to more volume, which leads to additional trades which leads to more volume.
The CME has the highest volume across many of the products that are traded on its exchange. This almost makes the CME a natural monopoly in my mind. I’ve been a big fan of the CME business model for a long time.
Where is the growth?
The ability of the CME to grow revenues is based partly on its ability to push through contract price increases as well as its ability to add additional products for traders to trade. Given its market dominance as an exchange, it’s been fairly successful in being able to push through price increases on contracts traded on its exchange and has managed a 6-7% price increase on average contract price over the course of 2012.
The CME is also constantly looking to roll out new products to be traded on the exchange. Over 2012, it has launched new interest rate swap contracts, new carbon emissions contracts as well as new natural gas and power contracts.
What do the numbers say?
CME compound revenue growth over the 10 year period (2002-2011) has been an impressive 24% p.a, quite extraordinary growth. It should be noted that this was helped by the acquisition of the Chicago Board of Trade that created a spike in revenues and operating cashflow in 2007.
The acquisition effect can be seen in a breakdown of the numbers. While both “halves” have had good relatively revenue growth 2002-2007 revenue growth was a spectacular 30% p.a while. 2007 to 2011 has been a more modest 17% pa, slower but still pretty respectable! While growth in the 2007-2012 period has been decelerating, a 17% p.a growth rate is fairly good over a 5 year period.
CME compound operating cashflow over the year period has also been a very impressive 28% p,a.
We see the acquisition effect in the two periods comparison. 2003-2007 increase in yearly cashflow was 42% p.a for the period. while 2007-2012 was 13% p.a. 13%p.a while a marked slowdown from the earlier period is still acceptable
CME has had a dividend in place since 2003. During this year period, the dividend growth rate has averaged an impressive 31% p.a compounded. This is roughly in line with operating cash flow generation at CME over the period. And in the last 5 years? CME’s dividend from 2007 to 2011 has increase 13% p.a over this period, again in line with operating cash flow growth.
This suggests to me that CME has largely funded dividend increases through to 2011 via organic growth, given consistency of the dividend growth with operating cashflow growth. A review of the payout ratio in 2011 confirms this and indicates an untroubling 20% payout. I note this has been increased in 2012 to around 35% as a result of the declines in the contract volumes that we discussed above.
It should be noted that the contract volumes for some of the contracts that are traded on the CME declined over the course of 2012. Interest rate contracts and equity volumes contracts were sharply down over the year as a result of low levels of volatility (fluctuations in price), which resulted in a reduced need to hedge. Certainly with interest rates at all time lows, this has led to an unnatural decrease in interest rate volatility, reducing demand for interest rate hedging and therefore interest rate futures contracts.
The Chicago Mercantile Exchange is a fine business with an exceptional business model in my view. It has produced solid revenue growth over an extended period of time, with good operating cashflow generation. Dividends have also been increased strongly, consistent with operating cashflow generation.
My view is that the declines seen in 2012 contract volumes are likely to be temporary. We haven’t seen a new environment of lower than normal risk. Rather, once economic activity picks up again, I think CME will be well poised to return to strong revenue and cashflow growth. That means the right conditions for continued dividend growth.
I am adding an initial $5500 position to the Integrator $50k fund at $53.5, with a view to adding more should the CME price decline below $50.