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CME Downgraded to Underperform

ICE CME

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We are downgrading our recommendation on CME Group Inc. (CME - Analyst Report) to ‘Underperform’ from ‘Neutral’ based on its disappointing first-quarter 2012 earnings that lagged on a year-over-year basis. Lower-than-expected volumes, clearing and transaction fees and higher operating, non-operating and tax expenses affected the top line and operating margin.

CME reported its first-quarter 2012 operating earnings per share of $4.02, which were at par with the Zacks Consensus Estimate, but lagged the year-ago earnings of $4.36 per share. Net income slipped 8.9% to $266.6 million.

CME’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 lead to a decline in the customer demand. Although the company has diversified product offerings, it is still immensely dependent on the trading volume of two product lines - interest rate swap and equity - for a significant portion of its clearing and transaction fee revenues, which again contributes significantly to net revenues.

Moreover, the trading activity is inherently variable, both seasonally and cyclically, whereas many of CME’s costs are fixed. Besides, the ongoing consolidation in the industry remains a challenge for further market share gains. Recently, arch-rival IntercontinentalExchange Inc. (ICE - Analyst Report) launched competitive grain derivative contracts with lower margin costs and expanded trading hours that also impelled CME to follow suit. Moreover, the company also failed to takeover London Metal Exchange that could boost the former’s Comex metal exchange.

Nevertheless, on the positive side, CME holds 98% market share of the U.S. futures trading with a clearing house notional value of over $35 trillion. Operating leverage is another key positive. Increased electronic trading volume adds scalability (and hence leverage) to CME’s operating model and has also helped the company maintain an operating margin of over 60% coupled with consistent bottom-line growth, in the past 4 years. Besides, the BM&F Bovespa exchange in Brazil, non-transaction related opportunities and potentially the over the counter (“OTC”) offerings should continue to contribute modestly to the top-line growth in 2012.

Although market volatility, increased competition and regulatory concerns are pruning CME’s industrial position, it has been able to reduce its total debt to $2.1 billion in 2011 from $2.5 billion in 2010. Further, the company had excess borrowing capacity for business operations of approximately $1.0 billion at the end of 2011.

Overall, the company’s efforts to promote, expand and cross-sell its core exchange-traded business through strategic alliances, meaningful acquisitions, newer product initiatives along with its global presence should drive decent growth in the long run.

The Zacks Consensus Estimate for CME’s second-quarter 2012 currently stands at $4.01 per share, down about 8.4% year-over-year. For 2012, the Zacks Consensus Estimate stands at 16.51 per share, down 3.1% over 2011.

CME currently carries a Zacks #4 Rank, which implies a ‘Sell’ rating for the short term.

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