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Try this global blue chip – Chicago Mercantile Exchange Group

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Uday Cheruvu

How long have you held Chicago Mercantile Exchange (CME) Group?

We invested in Chicago Mercantile Exchange Group in April 2012 when the stock was trading on 13 times forward PE, in line with cash equity exchanges (historically Chicago Mercantile Exchange Group has traded close to 30 times forward earnings and at a significant premium to cash equity exchanges). The market had become overly bearish on the stock and was viewing a cyclical downturn in volumes (post GFC) as a structural issue. Thus, we took advantage of the relative mispricing.

What do you like about it?

Chicago Mercantile Exchange Group is the largest interest rates, equity, commodity, energy and currency futures exchange in the US. Exchanges are attractive, scale businesses, which have low capex needs and provide a high ROE. We favour futures exchanges over other exchanges, as they do not face the competition risk equities exchanges face, and their trading exclusivity results in minimal market share risk and pricing power. Chicago Mercantile Exchange Group has a near monopoly position and faces no viable competition in the medium to long term, which, combined with an intrinsically high return business model, makes it an attractive long-term investment.

How is it better than its competitors?

Chicago Mercantile Exchange Group has a near monopoly position and has shown the ability to exercise pricing power. Chicago Mercantile Exchange Group’s monopoly position has been derived from its vertically integrated business, providing both a trading platform and clearing house. The clearing house locks in the customer base, as contracts are not fungible. Thus, competitive threats for Chicago Mercantile Exchange Group are minimal and it has maintained 90% plus market share, even while exercising pricing power and repeated attempts by large competitor exchanges, such as NYSE Liffe to take market share.

Chicago Mercantile Exchange Group (CME)

Equities can be traded on any exchange, irrespective of where they were originally listed, but futures contracts can only trade on the exchange that is associated with the clearing house, so traders are essentially locked in. The cost associated with closing and opening positions is significantly higher than any benefit gained from lower transaction fees.

What do you like about its management?

In our view, we believe management to be very good operators and not interested in acquisitions for the sake of growth. They are tight on costs, know how to retain clients and prefer dividends to buybacks.

What is your target price?

At normalised volumes, it would equate to = $4+ Earnings per Share = 23x-25x = $US92-$100

At what point would you sell it?

The largest potential risk to Chicago Mercantile Exchange Group’s business model is if US regulators seek to break up its business and make its clearing house accessible to other exchanges in order to increase competition. This risk is minimal, as regulators in both the US and Europe have conducted a number of studies and concluded that it is legally unmanageable to allow open access to Chicago Mercantile Exchange Group’s clearing house. However, if this were to eventuate, we would look at reducing/selling our position.

If the stock reached our price target, we would also look to sell our position.

How much has it added (subtracted) to your overall portfolio over the last 12 months?

The average price we have paid for the stock is $48.19, the stock is currently $81.14. Until June 2013, the stock has added 1.4% to the overall fund performance, with the fund currently holding a 1.9% position.

Where do you see the value?

Our analysis indicates that as US interest rates and yield curve returns to normal levels (i.e. higher than current), trading activity on the Chicago Mercantile Exchange Group will increase significantly. As the Federal Reserve and other central banks indicate that they are looking to reduce QE measures, there will be greater volatility in financial markets and hedgers and speculators will increase their activity in this changing environment. This increased activity will underpin revenue growth and, subsequently, result in a 10% plus normalised EPS growth for Chicago Mercantile Exchange Group over the medium term. At current consensus, an FY14 multiple of 20 times still does not reflect the full potential for long-term volumes rebound. We believe as Chicago Mercantile Exchange Group’s volumes and earnings begin to show 10% plus growth, the returns for the business will increase and be reflected in Chicago Mercantile Exchange Group’s share price.

Uday Cheruvu joined PM CAPITAL in 2008 and holds a Bachelor of Engineering and a Bachelor of Commerce, both with Honours, from the University of Melbourne, as well as a Master of Applied Finance from Macquarie University. Uday has a background in both private equity and investment banking, in equity and credit analysis.

Uday has experience in financial modeling and creating financial (credit based) models for hybrid instruments in the Australian market. At PM CAPITAL Uday analyses the global financials sector as well as credit related opportunities for the Enhanced Yield Fund.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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