CME Group's Results Are Not As Bad As They Appear
The CME Group's ( CME ) Q1 performance looks worse on paper than it actually is. The company reported last week that its total revenue for Q1 2013 declined by 7% y-o-y to reach $718.6 million. Both transaction based and non-transaction based revenues were down. Transaction and clearing fees, which accounts for more than 80% of CME's total revenue, declined by more than 4% y-o-y. On the other hand, the revenue from market data and information services declined 29% y-o-y to reach $81 million. The company's operating income for the quarter was $405.5 million, down 10% compared to the year ago figure.
We believe that the company's overall performance is not actually as bad as the above numbers suggest. The decline in transaction based revenue must be looked at in the context of fewer trading days in the quarter and a changing product mix for the company. Similarly, when looking at the decline in market data revenue, one must bear in mind that the company contributed a part of that business to a joint venture in June last year and hence those revenues now appear as non-operating income rather than market data revenues.
Nevertheless, there are still some areas of concern for the future. Increased competition from the IntercontinentalExchange remains a serious threat to the company's dominance in the derivatives marketplace. We are also worried about the firm's market data division as it faces slacking demand due to high unemployment levels in the financial services sector and aggressive cost cutting at customer firms.
Lower Number Of Trading Days
Q1 2013 had two fewer trading days than the same quarter last year. This directly impacts trading revenues because the exchange lost out on the additional transaction based revenue that it could have generated over those two days. Our estimates suggest that the company's revenue could have been higher by almost $20 million at current average daily volume (ADV) if it operated for two more days in the quarter.
Adjusted for 62 trading days
|Average Daily Volume (ADV) (in '000s)||12,308||12,484||12,484|
|Average Rate Per Contract (in $)||0.811||0.785||0.785|
|Avg. Daily Transaction And Clearing Revenue ($ millions)||9.98||9.80||9.80|
|Total Transaction and Clearing Revenue ($ millions)||618.87||588.00||607.60|
|Difference ($ million)||19.60|
Changing Product Mix
Another factor that negatively impacted CME's transaction based revenue in this quarter was its changing product and member - non-member mix. This caused the overall average rate per contract to decline from $0.811 in Q1 2012 to $.785 in Q1 2013.
Changing Product mix: The company's product mix changed this quarter as the volumes of lower average fee products (such as interest rate contracts) increased at a faster pace than the volumes of higher average fees products (such as agricultural and energy contracts). This contributed to the reduction in the overall average rate per contract.
Changing Member - No-member mix: Member clients usually pay less per trade than non-member clients. Hence there is an incentive for frequent trading entities to take membership of one of CME's platforms. While this reduced the transaction expense from clients, the exchange's average rate per contract (RPC) goes down marginally at the same time.
Note that while these two factors cause the company's average rate per contract to shrink, the company gains at the same time due to higher volumes and increased membership fees. Further, the decline in average rate per contract is not a permanent feature and could reverse when the company attracts more non-high-turnover customers or develops new products that generate higher average fees.
Discontinued Index Services Business
In June 2012, the CME Group contributed a part of its Index Services business to a new joint venture with The McGraw-Hill Companies Inc. (McGraw). The income from that business is now classified as non-operating income and is not reflected as revenue from market data and information services. Hence, when compared to Q1 2012, the decline in revenue from this division looks more severe than it actually is. We are likely to see a similar impact in Q2 figures as well, and things will normalize from Q3 onwards.
Foreign Exchange Losses
The company announced that it was impacted by a foreign exchange transaction loss of $12 million related to "cash held in British pounds within foreign entities whose functional currency is the U.S. dollar." This is one-time loss and is unlikely to repeat consistently going forward.
So Does That Mean Everything Is Rosy?
We believe that the fundamentals of the CME Group are solid as volumes continue to grow at an impressive pace. However, there still are a few problem areas that we continue to monitor closely.
Increased competition: The CME Group is facing increased competition from the IntercontinentalExchange in the energy contracts segment. In fact, last year the monthly trading volume of Brent oil futures offered by ICE overtook the volume of West Texas Intermediate ( WTI ) crude-oil futures traded on CME's New York Mercantile Exchange.
This is a serious threat to CME's dominance of the derivatives marketplace because traders eventually gravitate towards the most liquid markets. The threat is also high because ICE is in the process of acquiring NYSE Euronext and is likely to leverage NYSE's Liffe derivatives operations to capture the growing derivatives market in Europe once the acquisition gets completed.
Market data is not performing well: Even if we adjust the market data and index services revenue to account for the business that was contributed to the JV with McGraw, CME's market data and index services division does not seem to be doing too well. The company still seems to be ailing from a decline in the average number of market data devices due to the continued economic uncertainty, high unemployment levels in the financial services sector and aggressive cost cutting initiatives at customer firms.
What Is CME Group Doing To Retain Market Share?
The CME Group has been offering incentives in the energy contracts segment in order to attract volumes. While that also pulls down the average rate per contract, it is necessary because it helps in generating volumes in that segment. The company's efforts seem to be getting some initial success, and it remains to be seen how the situation evolves.
In Europe, the company has already launched an interest rate swap clearing capability and is only behind Eurex and LCH.Clearnet in supporting European buy-side firms. The firm also plans to launch a derivatives exchange in London by mid-2013, in order to compete with Eurex and Liffe for OTC derivative volumes.
Our price estimate for the CME Group is around $57, slightly below its current market price.
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