CME -- monopolies generally make good investments

When writing my last post about AAPL and RIMM, I could have easily included CME -- the Chicago Mercantile Exchange. Its a stock that is up substantially since coming public but again -- what matters is the future earnings power vs. current investor expectations and the probability that CME's earnings power will exceed expectations.

First, some background on CME. I first learned about the story when the stock was in the low $300's -- it was "expensive" at the time based on the consensus estimates but the company managed to produce earnings well in excess of those estimates -- today the stock closed at over $580. I wasn't willing to bet on the continued growth in the futures contracts that are traded at the Merc so I passed on the stock and it went up almost $300 without me. A couple of years later and I have a better understanding of the company and the growth picture.

CME is a virtual monopoly because of the liquidity they provide in the futures and options contracts traded at the Merc exchange. The business model is similar to eBay except that the products traded at the exchange are all financial related -- equities, interest rates, foreign exchange and commodity futures. CME gets a cut from every contract traded -- like collecting tolls on a highway for each car that drives by, CME collects a fee every time a hedge fund, institution, company or individual trades a futures contract at a CME exchange.

The growth of hedge funds as well as the need for traditional institutions to control risk and become more competitive with hedge funds has led to almost 30% annual growth in contract volumes. CME is also benefiting from trading moving to electronic forums like CME Globex -- margins are higher because the costs are lower.

Growth drivers -- 1. growth in alternative managers that use derivatives to manage risk and or speculate for higher returns. This is a secular trend for managers to deliver better risk adjusted returns in all environments. Derivatives provide flexibility.

2. Secular trend towards electronic trading -- helps margins.

3. move from OTC to centralized electronic exchanges like Globex -- secular trend as investors seek best sources of liquidity plus transaction speed. CME's fees are a low percentage of the total cost of a contract.

4. Merger with CBOT -- provides equity options and other derivatives. CME gets to diversify revenues by adding new product areas plus they should be able to introduce new products that take advantage of their new combined strengths. Costs should drop as they leverage technology costs.

The stock is near its highs but it hasn't done nearly as well as RIMM or AAPL. The estimates for CME are low -- all previous years they have showed strong growth from Q1 to Q2 and yet this year estimates assume zero growth. Revenue growth is expected to decelerate sharply over the next several quarters and yet trading volumes (already reported) hit record levels in the month of June and show no signs of slowing.

I expect the merger to have a positive impact on estimate revisions. Running an exchange is about high start up costs yet low incremental costs as volume builds -- i.e. high operating leverage. Margins hit 60% last quarter. Free cash flow is equal to reported earnings. Returns on assets equals 28%. Trading goes to where the liquidity is -- CME dominates the trading of futures and other derivatives which has created a virtuous circle whereby more trading equals more liquidity which encourages more trading etc.

High returns, big competitive moat, strong secular growth trends, low estimates, etc. -- for me that equals a high probability this investment will outperform.

I sold my ACAS position to buy the CME. After purchasing ACAS, I discovered the overlap with DFR was greater than I realized and the movement towards increasing management fees was likely to take longer than I first thought. While ACAS will likely do fine, I would rather diversify my exposure a bit -- more confidence in DFR's ability to navigate current private equity related debt trends and in DFR's growth prospects.