The CME: Why Are Investors So Gloomy?

The world's largest futures exchange is posting record profits and gobbling up rivals amid the commodities boom, but its stock is in the dumps

The dark storm cloud of worry hanging over the CME Group (CME) is astonishing for a company that is expected to boost profits 25% this year. The CME's stock is down 30% so far this year, despite plenty of good signs for the Chicago-based futures exchange, the largest in the world.

CME has had success wringing savings out of its hard-won merger with the Chicago Board of Trade (CBOT) last year. It's more than halfway to its goal of $150 million in savings from the combination with its crosstown rival.

The exchange continued its acquisition streak, making a deal Mar. 17 to buy the New York Mercantile Exchange (NMX), or Nymex, at what some analysts think is a cheap price. The deal is expected to close before the end of the year.

The key driver of CME's results is the number of trades processed on its exchanges, which handle commodities, stock index, foreign exchange, and commodity futures. Trading volume started the year in record-breaking fashion, and though it has backed off since, volume remains strong.

Threat-Free, for Now

With the Nymex acquisition, CME will gain that exchange's busy energy-trading pits—a hot part of the futures space with oil trading above $126 per barrel. Nymex said May 16 that April's average daily trading volume was up 22% from a year ago.

The CME saw earnings per share jump 26.6% in the first quarter from a year ago. And according to Reuters Estimates, analysts expect CME to increase earnings 25% for all of 2008 and more than 20% in 2009.

Also, CME is expanding internationally in places as diverse as Brazil and South Korea. "There continues to be tremendous opportunity in penetrating the global landscape," writes Credit Suisse (CS) analyst Howard Chen.

So what's the problem? Why are CME shares down 30% from the start of the year, wiping out the stock's 2007 gains? The CME is facing an array of long-term threats. Although none of them are squeezing CME's bottom line right now, investors are clearly worried they will.

Volume Control

Start with volume. Many worry the recent financial crisis is forcing financial institutions to rely on a lot less debt, or leverage. This de-leveraging may give traders a lot less money to play with on CME's exchanges.

Volume on exchanges had a stellar first quarter, helped by volatile conditions as financial panic peaked and the U.S. economy seemed to slip into recession. But the second quarter has been a disappointment. CME and CBOT volumes so far are down more than 25% from the first quarter, JPMorgan (JPM) analyst Kenneth Worthington wrote May 9. However, second-quarter volumes are often "seasonally slower" and remain strong compared to a year ago, he wrote.

So is de-leveraging hurting the CME? The threat is real, but CME executives and at least some analysts seem to doubt it.

Keefe, Bruyette & Woods (KBW) analyst Niamh Alexander expects computerized traders will continue to add volume to the CME. The exchange is also "at a competitive advantage to less capital-efficient and less transparent [over-the-counter] markets," which will bear the brunt of de-leveraging, Alexander wrote.

Rival Territory

Another worry for CME is competition. Several large financial players are launching a new rival exchange, to be called the Electronic Liquidity Exchange. Though still in the planning stages, "we worry that CME may have to cut prices in response to the competitive threat," says Deutsche Bank (DB) analyst Rob Rutschow.

Then there is the threat that government actions could hurt CME's profits. Regulators have expressed worry that the growing CME is getting too big and dominating its markets. Meanwhile, the spike in oil prices has raised scrutiny of energy markets; new regulations could squeeze profits at the Nymex (, 5/15/08).

CME's stock is also being dragged down, at least in the near term, by the long, complicated process of winning approval for the Nymex acquisition. There is speculation CME may have to increase its bid to win over Nymex members and shareholders, even if no other bidders emerge. News of negotiations leaked out in January, and analysts say the deal probably won't close until near the end of the year. "Meaningful share price outperformance may be difficult to achieve until Nymex deal resolution," Chen says.

Despite the formidable problems, the CME remains a powerful player in global financial markets. If the clouds lift, patient investors could be handsomely rewarded.

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