The Merc Is Far from a Hot Commodity

You know all those Chicago traders, the ones who scream and body slam like a pack of overage punk rockers? Picture this: They're hoping you'll help finance their mosh pit.

The particular pit in question is the Chicago Mercantile Exchange. The nation's busiest arena for buying and selling futures contracts, the Merc is in the final stages of a long-awaited plan to go public. Aimed for the first week of December, the initial public offering is set to raise an estimated $154 million (table) in exchange for about 20% of the Merc's parent, Chicago Mercantile Exchange Holdings.

Chief Executive James McNulty and other Merc execs are keeping mum ahead of the deal. Yet the Merc's securities filings spell out how, in some ways, business has never been better. Trading volume this year through September soared 40%, as investors kept rushing to bet on--or hedge against--moves in interest rates, currencies, stock indexes, and, even still, such original Merc commodities as butter. All told, revenue from executing and clearing trades, plus more from such ancillary sources as sales of market data to brokerage firms, jumped 18% in the nine months ended Sept. 30.

That's all to the good. However, prospective investors also will want to examine some less alluring aspects of the deal. What's particularly striking about the Merc is the gap between the flood of money rushing through it and how little it siphons off. Last year, for example, $294 trillion--that's trillion, with a T--in contracts changed hands at the Merc. Yet it netted just $68 million on revenue of $387 million. So, despite its big hat, the Merc in fact owns few cattle.

Perhaps more immediately alarming is a recent erosion of profitability. That's because the Merc has been discounting. Through the Merc's first nine months last year, it was able to collect an average of 71.7 cents per contract traded. So far this year, the average has sunk to 63.2 cents a contract. If that level persists through the fourth quarter, the Merc's average rate per contract will be lower than it has been since 1998. Nor is that the only weak spot as distress in the broader financial-services business bears down. Through September of this year, the number of brokers' computer screens showing Merc data shrank by 10,000, to 180,000. As you might expect, all of this has put a squeeze on operating margins, which shrank by two percentage points, to 30%, through September.

Much of the Merc's business is cyclical, and margins may one day expand again. But another worry that figures to persist for outside investors is the giant conflict of interest facing 17 of the Merc's 20 directors. This is a group that also represents Merc member firms--the traders and brokers who own the right to scream, slam, and otherwise conduct business in the pit. As Merc members, these 17 directors will want to keep a lid on trade execution and clearing fees, which are the Merc's greatest source of revenue and profit. "Consequently," the Merc's filing notes, "members may advocate that we enhance and protect their clearing and trading opportunities and the value of their trading privileges over their economic interest in us."

These are not propitious days for bringing IPOs to market, a fact that might make some investors see shares in the Merc as an out-of-season bargain. Yet at an indicated $32.50 a share, the Merc is not coming to market cheap. That price would give the Merc a total market value of more than $1 billion, or about 14 times the past 12 months' net. Just the same, don't bet against this deal finding a way to get done. CEO McNulty has a potent incentive to complete the IPO: He holds enough stock options that if he were to cash out at $32.50 a share, he would come away with $31 million, plus $8 million more a year later. So forget the mosh pit. For outside investors, the Merc looks like a money pit.

By Robert Barker

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