CME Group: Uncertainty In The World Equals Higher Revenue Growth (NASDAQ:CME)

Investment Thesis

CME Group (NASDAQ:CME) is going to report its FY23 earnings on the 14^th of February before opening, so I wanted to take a look at the company’s financials to see how it has been progressing over the years and whether it would be a good time to start a position. With a lot of uncertainty in the economies, which brings a lot of volatility to the markets, the trading activity increased from the company’s historical figures, thus improving revenue growth, I believe the ongoing uncertainty will be a positive catalyst for the company in the upcoming years and we will see higher revenue growth than previously observed. Coupled with a strong balance sheet, the company is trading at a slight discount to its fair (yet conservative) value, therefore, I am assigning the company a buy rating.

Briefly on the Company

CME Group is a provider of a platform that facilitates the trading of futures and options contracts worldwide. Their platform CME Globex connects buyers and sellers of these contracts to make deals. Many brokerages indirectly source CME’s data through market data providers, or MDPs, like MarketAxess (MKTX) or Refinitiv, for example, Interactive Brokers (IBKR) would subscribe to data services from these MDPs.

The company also offers clearing services, which means that they guarantee that every trade is going to be completed, even if one party ends up defaulting. Clearing services come with additional fees.

Financials

As of Q3 ´23, the company had around $2.4B in cash and equivalents, against around $3.4B in long-term debt. That is a strong position to be in. It doesn’t look like the company is over-leveraged, but to make sure, I look at some solvency metrics. Firstly, the company’s debt-to-assets ratio is well under my threshold of 0.6, so in terms of assets, it is good. Secondly, the debt-to-equity is well under 1.5. Lastly, I like to look at if the annual interest expenses on debt are manageable. I like to look for at least a 5x interest coverage ratio, while many analysts look for at least a 2x. I like a 5x because it gives a lot more leeway for bad years of performance when EBIT may not be as robust as in the past, and still be able to meet the debt obligations. The coverage ratio as of Q3 has been over 20x, so even with my more stringent requirements, the company passes. Three for three. It is safe to say, the company is at no risk of insolvency.

The company’s current ratio has been solid and consistent at around 1 for at least the last decade. So, the company has no liquidity issues either.

In terms of margins, the company doesn’t separate its COGS from its expenses, so there is no point in looking at the company’s gross margins, as they will be 100%, however, CME’s EBIT and net margins are very healthy, and have recovered nicely since the beginning of 2021. The company is in a very high-margin business, which I like to invest in.

Continuing on with efficiency and profitability, I’m a little disappointed that the company’s ROA and ROE are quite low given the fact that the company has such a robust bottom line. The company is very asset-heavy due to the company’s performance bonds and guaranty fund contributions, which are funds that are set aside as protection against losses if a member of their clearing house fails to meet its financial obligations. So, in essence, this is an insurance policy, but the members are not paying premiums, but rather contribute to the money pool directly. The contributors to this pool of money are the members of the CME clearing house, the companies that facilitate trading. This cash is then invested in risk-free securities like CDs, money market funds, and other government securities. The gain on these funds is under the item “Investment income” on the income statement, which in the latest quarter earned $1.27B. I would like to see higher ROA and ROE numbers from the company going forward, but I’m not sure if that is possible when such an asset is involved where the company doesn’t have much power in how to use it, as it is more of a protection rather than an item to make us in further the growth of the company.

In terms of its competitive advantage, there aren’t many that do what CME does and are publicly traded, but the companies that do, one of them is similar in terms of size, while the other is about a third of the size and half the size, so the comparison between them isn’t perfect. It is a highly competitive business segment with many different players that are not public companies like LCH, which is part of the London Stock Exchange (OTCPK:LDNXF), or the OCC. However, I will include LSE there too for extra comparison. We can see that CME’s return on total capital is somewhere in the middle or close to the top if we take out the CBOE (that is the one that is less than a third of the size of CME), so CME is doing relatively well for its size. I would like to see at least 10% here, however, it looks like it is not an easy feat to achieve in this business.

In terms of revenues over the last decade, it’s not been very exciting at all. Over the last decade, the company managed to squeeze out around 6%, and the growth has been declining in recent years, which is not particularly great. This will deter many investors who are looking for top-line growth, but if the company can improve its operations via improving margins, the value will come.

Overall, the company has been operating very consistently over the last decade or so, which is better than going down, but not as good as consistent growth across the board. In the most recent years, we did see some operation efficiencies come through but that just brought its efficiency back to where it was a few years ago. I would like to see the growth continue, but only time will tell.

What to Expect from Upcoming Earnings

Analysts expect GAAP and adjusted EPS to be $2.18 and $2.28, respectively, on $1.43B revenues. The management doesn’t provide a top-line figure for the upcoming Q4, but I would assume it’ll be close to analysts’ expectations. Speaking of expectations, the company beat EPS 12 out of the last 12 quarters, while missing 5 on revenue. So, the company has a high chance of beating EPS but may miss on revenue.

The management did give us guidance on expenses, which should be around $1.535B for the year, excluding license fees. For the full year, analysts are expecting almost 11% top-line growth for FY23, which is much higher than its average, and the years after that drop off to around 3%. I don’t take these estimates too seriously because it is hard or virtually impossible to predict what the company is going to do more than a couple of quarters out, especially with so much uncertainty in the economy.

Comments on the Outlook

I think the uncertainty of the macro environment is a good thing for CME. Uncertainties bring volatility, which means many clients will be looking to hedge their positions, in turn increasing trading activity and increasing revenue growth for CME. I am not too surprised to see that FY23 estimates are low double-digits in revenue growth, because we had a very choppy and uncertain year, and only in the last 3 months of the year where everything just started to rally, but before then, the markets were choppy (but generally trended up). This uncertainty is what drove the company’s top-line growth. As we just saw the U.S. jobs growth is alive and well, which means we can kiss goodbye any rate cuts in March and I am not too hopeful for a cut in May either. My guess is there will be a lot more volatility over the next year, which going to bode well for companies like CME, who thrive on trading activity.

The number of stock index options and futures contracts traded in the first half of ´23 increased by around 81% y/y, due to options volume surging over 100% during the period. Most of the trading volume came from the APAC region, which was around 89% of the total volume of contracts traded. Options have become very popular among many investors due to their leverage and potential for huge gains in a short period, however, most options expire worthless, and the big outliers happen not too often, so most people end up losing a lot of their money because options are very risky due to their leverage effect. A recent example of options profit being unrealistic expectations and a gamble is Meta Platforms (META) earnings beat. If you would have bought half an hour before the market closed on the earnings date a deep out-of-the-money option, say 450C expiring on the 2^nd of February for 38 dollars, the next morning right at the open, you could have sold the contract over $2,000, or if you waited a couple of more hours, you could have walked away with $3,500, which is around 9,100% of your initial investment. That is why options are so popular and no doubt it was spurred by the meme mania of the GameStop (GME) era of a few years ago.

As options become so popular, so does cryptocurrency. If the company continues to innovate and offer more products related to cryptocurrencies, this will attract many more investors. The company already offered some Bitcoin and Ethereum futures for the last couple of years and also options, however, expansion into other cryptos would do well but a lot of those cryptos are nothing but scams so there is a lot of risk in committing to a coin that may be fraud, although I’m not sure if there is any value in bitcoin and other more prominent coins, other than speculative plays.

In short, I believe options volumes will continue to increase throughout the years and I wouldn’t be surprised if the company’s top-line growth rejuvenates and reaches new, more robust levels than in the past, with further technology advancements that allow for instant transactions and ease of use.

Valuation

Let’s put a fair value on the company. In terms of revenues, I went with conservative estimates past FY23, to give myself a higher margin of safety and more room for error in my calculations. I went with around 4% CAGR over the next decade in my base case. To cover my bases, I also modeled a more conservative outcome and a more optimistic one. Below are those estimates, and their respective CAGRs.

In terms of margins and EPS, I went somewhere in the middle between GAAP and adjusted estimates that the analysts are modeling. This way I’m not too conservative and not too optimistic about the future of the company. Below are those estimates.

For the DCF model, I used the company’s WACC of around 6% as my discount and also a 2.5% terminal growth rate. To be on the even safer side, I went ahead and discounted the intrinsic value by another 20% to account for any errors in calculations, which will act as a further margin of safety. With that said, the CME’s intrinsic value is around $217 a share, meaning the company trades at around a 5% discount to its fair value.

Risks

Regulations may impose higher costs on CME Group that could potentially hurt trading activity and its top-line growth.

Competition is one of the bigger risks that the company faces, which may continue to deteriorate its edge if the competition can offer a better fee structure. This may take market share away from CME.

As I previously said, the company may benefit from overall uncertainty in the economy, but if we see an economic slowdown, this may lead to lower trading volumes and a decreased risk appetite, which will not be great for CME’s top-line growth.

Closing Comments

So, it looks like it may not be the worst time to start a position in a company, that is a leader in the industry, and it is never a bad time to invest in a leader that is certainly going to stay around for a while and may continue to perform well. A steady, somewhat boring growth is good in my opinion, and advancements in technology will make the company’s services more reliable and up-to-date to compete in such a fast-paced environment. Therefore, I initiate my coverage of the company with a buy rating, as I believe in the long term, the company will deliver great results.