CME CME Group Inc

We reiterated our ‘Neutral’ recommendation on CME Group Inc. (CME) based on the current sustainability factor. The company reported its second-quarter earnings of $293.7 million or $4.38 per share, way ahead of the Zacks Consensus Estimate of $4.17. The earnings also surpassed the prior-year earnings of $270.7 million or $4.11 per share.

The improved result in the reported quarter was primarily attributable to moderate volume growth and strong expense management that also offset the higher share count factor. CME Group continues to post modest average volumes with significant growth across the entire product spectrum.

Further, the company has been making endeavours to drive its top line through new portfolio diversification and product launches, primarily in the area of the rapidly growing energy contracts. Moreover, CME Group is also extending its OTC offerings to the important emerging markets of Europe, Asia and Latin America.

This is also crucial for CME Group given the significant ongoing consolidation activity in the industry. Hence, we believe that a notable acquisition is probable in the near future in order to enhance the company’s competitive leverage and increase its non-US volume by spreading its global footprint.

CME Group also enjoys a strong capital and cash position that stemmed from modest operating cash flow, which helped in debt reduction as well. Further, the company had excess borrowing capacity for business operations of approximately $1.0 billion at the end of June 2011. The substantial free cash generation and lowered capital expenditure also supports the recent new share buyback program and the dividend hike along with other capital expending in 2011, thereby adding to the company’s financial flexibility and investors’ confidence.

On the flip side though, increased expenses, primarily escalated compensation and benefits, continue to be the downside. Higher capital commitments required for OTC initiatives and CME European Clearing further require increased cash outflow. Followed by higher expense guidance for 2011, a rising trend in compensation and benefits expenses has elevated the operating risk and in turn adversely impacts the bottom-line growth.

Further, CME Group’s diversified product portfolio is significantly exposed to extreme interest rate volatility, firm government regulations and limited credit availability in the current unstable capital and credit markets, which can hamper liquidity and can also cause a decline in customer demand lest this trade scenario remains intact or worsens in the future.

Additionally, CME group’s businesses are strongly affected by intense competitive pressure. Particularly, the anticipated merger between NYSE Euronext Inc. (NYX) and Deutsche Boerse are also expected to directly as well as sharply hit the company’s derivative business. Even other operators such as IntercontinentalExchange Inc. (ICE) and CBOE Holdings Inc. (CBOE) are making good attempts to penetrate the emerging markets.

The ongoing market sluggishness coupled with intense competition is also a taking a toll on CME Group’s volumes and pricing. In the near term, the average rate per contract for futures and options shall continue to pressure revenue growth as incremental volume exceeds the fee ceiling on volume traded on the CME Globex platform, which warrants higher tier discounts. Going ahead, such consistent market downturn and price declines are expected to severely weigh on the company’s operations, volumes and financials.

An uncertain regulatory environment amid such volatile macro factors in both the primary markets of the US and Europe has caused additional furor in the industry and are expected to slow down volume growth of CME at least in the upcoming quarters, once the regulations are enforced.

Weighing all the pros and cons, the Zacks Consensus Estimate of earnings is pegged at $4.25 per share in the third quarter of 2011, up about 16% year over year. Of the 17 firms covering the stock, 9 firms have revised their estimates downward while 4 upward revisions were witnessed. For 2011, earnings are expected to be $17.19 per share, climbing about 11% from 2009.

Additionally, the quantitative Zacks Rank for CME Group is currently #3, indicating no clear directional pressure on the shares over the near term.

 
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