Profiting from the Crisis's Clean-Up

12/08/2008 11:23 am EST

Focus: STOCKS

Vahan Janjigian

Editor, Bottom Line's Money Masters Stock Report

Vahan Janjigian, editor of Forbes Growth Investor, finds a company that should gain as financial firms unwind their bad debts.

CME Group (Nasdaq: CME) is the largest derivatives exchange operator in the world. It includes the Chicago Mercantile Exchange, the Chicago Board of Trade (CBOT), and the New York Mercantile Exchange (Nymex).

These exchanges process futures and options contracts on a variety of asset classes.
Interest-rate products account for half of average daily volume (ADV) on these three exchanges, [which] topped 13.2 billion contracts in the third quarter, [for a] notional value of open interest currently about $35 trillion. [These products] include derivatives based on eurodollars, US Treasury securities, swaps, and other dollar-denominated interest rate securities.

Equity products include standard and mini-derivatives contracts on various equity benchmarks. Commodity and alternative investment products include derivatives on agricultural commodities, energy, base and precious metals, and other specialized asset classes.

CME owns and operates an internal clearing house, which clears, settles, and guarantees every transaction. In effect, it becomes the counterparty to every trade. This means customers do not have to evaluate the credit quality of numerous counterparties.

CME manages its own counterparty exposure by enforcing margin requirements and marking to market twice a day. Due to such precautions, no customer has ever realized a loss due to counterparty default.

CME generated 82.5% of revenues [so far this year] from clearing and transaction fees, 10.3% from quotation data fees, 2.9% from processing services for other exchanges, and 1.7% from access and communication fees. The remaining 2.6% came from sources such as rental income and building operating fees.

Trading volumes have soared due to the expanding use of derivatives as hedging vehicles; the increasingly sophisticated investor class, which employs derivatives for speculative purposes; a shift towards active investment strategies, and a boom in hedge funds that employ derivatives. The notional value of exchange traded futures and options has grown 36% on an annually compounded basis from 2002 to June 2007.

Pro forma net revenue grew 5.8% to $787 million, and the pro forma operating profit margin expanded 290 basis points to 65.8%. Higher debt levels related to the Nymex acquisition caused interest expense to jump to $17.9 million from $1.4 million in the [same quarter the previous year]. Pro forma net income grew 3.3% to $278 million or $4.13 per share.

Volumes in recent periods spiked due in part to deleveraging, redemptions, and liquidations by failed financial institutions. We expect volumes to remain strong because CME’s services are appealing to investors worried about counterparty risk. Furthermore, CME is working with regulators to develop a trading platform and central counterparty facility for credit default swaps (CDS).

The CDS market, which recently had an estimated gross notional value of $55 to $64 trillion, could represent a significant new revenue stream for CME. (The stock closed below $195 Friday—Editor.)

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