CME Worth The Risk?

By Wayne Pinsent | April 23, 2008 AAA

The CME Group (NYSE:CME) reported soaring profits as it was boosted by its combination with the Chicago Board of Trade. The parent of the world's largest derivatives exchange reported profits that more than doubled, but the stock still got crushed as the numbers missed analyst expectations. The drop could provide an entry point for investors who can handle a little risk.

Expecting More From The Merger
On Tuesday, April 22, CME Group reported first quarter net income of $284 million ($5.25 per share) compared with $130 million ($3.69 per share) a year earlier. The CME Group is the result of the Chicago Mercantile Exchange's acquisition of the Chicago Board of Trade last year. The combined entity has benefited by increasing its bottom line numbers, but the merger was expected to provide even more of a bang for the buck. The company also benefited from a change in the state tax laws. Excluding this benefit, the company earned $4.67 per share, missing consensus analyst expectations of $4.83 per share by 16 cents.

Top line numbers disappointed as well. Revenue rose to $625 million, up from $332 million a year earlier, but below the $630 million expected from analysts. The market has grown accustomed to CME beating expectations, so this miss came as quite a surprise, and investors sent the shares down 7.6%, or $40, to close at $483.50. At one point shares were down more than 12%, close to $460.

Troubles Ahead?
One troublesome takeaway from the quarter was that the volume of Eurodollar contracts dropped year over year. This is the company's biggest product line, and is a key indicator of the company's future growth. Since it serves as a driver for analyst estimates, you can look for estimates to come down slightly in the near term, although the drop on the stock has largely priced in this news.

Another trouble is that margins for traders have increased. This move was to reduce some of the speculation in futures contracts, due to ever-increasing commodity prices. This speculation is certainly something that regulators and the government would want to contain, but the CME eats up, since more speculation lead to more trades and more profits. The increase in margins may be leading to less trading.

Looking Forward
A lot of the problems can likely be attributed to market conditions, and firms reacting in an effort to reduce risk, and lower leverage to do so. This does impact CME and causes some added risk in the stock, but I still like the growth in the company. Also the risk of regulatory change proposed by Treasury Secretary Hank Paulson, seems to be dead in the water, at least for now.

CME Group is set to acquire NYMEX Holdings (NYSE:NMX), parent of the New York Mercantile Exchange, for around $9.4 billion, pending shareholder approval. This deal will even further solidify its status as the leader in futures trading. I think there will be further integration benefits to this deal, and I view the company's current growth as still impressive with the amount of risk that has currently come out of the market. I like the stock, but view it as a little riskier than its stock exchange counterparts due to valuation.

The stock currently trades at a higher price-earnings multiple than both the NYSE Euronext (NYSE:NYX), and Nasdaq OMX Group (Nasdaq:NDAQ), but also has high growth potential. Dangers of regulatory changes and prolonged risk averseness in the market make the outlook for CME Group a little more blurry, but I would recommend the stock on the downturn for those who are willing to take on a little added risk. (For background on the various exchanges, check out Getting To Know Stock Exchanges.)

The Bottom Line
CME Group posted first-quarter profit that more than doubled from a year ago, and still it failed to meet market expectations for the new combined options and futures powerhouse. True, the company missed estimates on both the top and bottom line, but it still has solid growth potential going forward. The shares reflect higher growth in their valuation, but overall I think the recent drop in the stock price is providing an entry point for investors willing to take on some risk.

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