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Analysts say CME stock will soar

Articles, Medill Reports

Published by the Chicago Journal and Medill Reports

By Christina Maria Paschyn
Jan. 24, 2007

Chicago Mercantile Exchange Holdings Inc. may be the “it” company of 2007.

In light of its coming merger with the Chicago Board of Trade parent CBOT Holdings Inc. and double-digit volume growth for the seventh consecutive year, some analysts say investors should buy, buy, buy CME stock, despite its lofty price-earnings ratio.

“I don’t want to say it’s a slam dunk,” said Morningstar Inc. equity analyst Patrick O’Shaughnessy. “But it’s pretty much close to that.”  He estimates the fair value price of CME stock to be $627, and he expects the price to soar even higher once the merger is completed in mid-2007, assuming prompt regulatory approval.  Yesterday the stock closed at $591.54.

“The company is very attractive and investors are not realizing it yet,” O’Shaughnessy said.

Analyst Scott Appleby of Deutsche Bank AG agrees.  He estimates a price target of $605 and rates the company as a buy.

“It’s a merger made in heaven,” said Appleby.  “We think the stock is going to go up when the merger is complete. And it already has!”  The stock traded at around $500 per share when the merger was first announced.

But how much more it will go up, he said, only time will tell. Its price-earnings ratio is already 54, compared to the 17.9 P/E of the Standard & Poor’s 500 Index stocks.

The Merc, which trades a variety of products from hog commodities to equity, announced its plan to merge with the CBOT in October 2006.  The combined company, to be named CME Group Inc., a CME/Chicago Board of Trade Company, is valued at $25 billion.

The CME and CBOT are complementary to one another, having zero product overlap.  Together they will form the world’s largest derivates exchange and will hold leading positions in several futures markets such as Eurodollars and soybeans.

“We now will be able to combine the capabilities and best practices of both organizations – establishing an even stronger, more competitive position than either could achieve individually,” said CME Chairman Terrence A. Duffy in a press release on the day of the announcement.

The Merc is prospering well on its own, too.  The company’s average daily volume for 2006 was 5.3 million contracts, up 28 percent from the year prior.

It also set volume records across all product lines in 2006.  Most notably, CME interest rate products daily volume averaged 3.1 million contracts for the year, up 29 percent from 2.4 million contracts in 2005.

This increase was driven by continued growth in CME Eurodollars options, up 44 percent to 1.1 million contracts per day compared with the year earlier.  CME Eurodollar futures grew 23 percent to 2 million contracts per day; they remain the most actively traded futures contract in the world.

The CME’s blazing volume growth coupled with its 2006 third-quarter earnings report has some analysts painting the company as a sure win for investors.  Third-quarter net income rose to $104 million from $77 million in the year-earlier period, a 34 percent increase.  Diluted earnings per share rose to $2.95 from $2.22.

Third-quarter revenues also jumped, to $275 million from $226 million in the same period last year, a 22 percent increase.  The company is expected to release its fourth-quarter earnings report on Jan. 30.

Appleby is predicting the fourth-quarter diluted earnings per share will reach $3.00 compared with $2.18 in the same period a year prior.

The exchange’s success is astronomical: CME began trading publicly on the New York Stock Exchange only in 2002 with the stock initially offered at $35 per share.  The price has rocketed since then, reaching a 52-week high of $590 on Jan 18.

But not everyone is head over heels for the company.  Fox-Pitt, Kelton analyst Edward Ditmire thinks the stock is overvalued and rates it as underperform.

According to Ditmire, CME is trading at too high a premium compared to smaller exchanges and companies.  Ditmire also thinks the combined organization won’t have any room to grow.

“When the merger between the CME and CBOT is completed, the combined company will own 100 percent market share of the futures market,” he said.  “Our underperform thesis rests on near-term volume growth slowing due to the relative maturity and already high market share of the largest products, rate and equity futures.  Smaller exchanges, however, have the opportunity to increase their market share.”

O’Shaughnessy disagrees.

“Even after the merger, the combined CME/CBOT company will still have plenty of room to grow,” he said.  “It will still be competing against Europe…And new products and innovations are constantly being created.  They get a 5 to 10 percent growth increase per year just from new traders coming in.”

O’Shaughnessy also dismisses concerns that the merger will create a CME/CBOT monopoly over futures trading, an issue currently being investigated by the Antitrust Division of the U.S. Department of Justice.

“The CBOT already has a monopoly in its own products and the CME has a monopoly in its own products,” he said. “They are different entities and not interchangeable.  And while putting them together will create a more complete portfolio for the CME, it doesn’t reduce competition.”

The exchanges also remain confident that the “completion of the merger will not violate antitrust laws,” according to the filing with the Securities and Exchange Commission.  In the filing the companies also state that, if anything, the merger will save their customers money.

CME and CBOT say the merger will generate expense savings of more than $125 million annually starting in the second year following the merger.  Cost reductions will primarily result from trading floor operations’ consolidation into a single facility at CBOT, with the eventual transfer of CBOT products onto the CME electronic Globex platform.  According to a research report by Sandler O’Neil & Partners L.P. analyst Richard Repetto, this should translate to $75 million in annual savings for customers.

Under the merger, CME is the acquiring company.  CBOT stockholders will receive .3006 share of CME Class A common stock for each share of CBOT Class A common stock.

CME Chief Executive Craig Donohue will serve as chief executive of the combined company.  The leadership team under him will consist of nine CME executives and one CBOT official.

Terrence A. Duffy, the current CME executive chairman, will keep that post while CBOT Chairman Charles P. Carey will become vice-chairman of CME Group.

CBOT CEO Bernard W. Dan for now will remain in his current position, overseeing CBOT’s activities, products and customers.  When the transaction is complete, he will serve as special advisor to the merged company for one year.

But the merger isn’t home free yet.  One remaining impediment comes in the form of the Chicago Board Options Exchange, the nation’s largest options market by trading volume.

Members of the Board of Trade claim they legally own about 60 percent of the CBOE because they provided the initial funding for it in the 1970s.

CBOE argues that CBOT members should be forced to give up their ownership claim if the company goes ahead with the merger.  Now CBOT is suing the options exchange to ensure its members can maintain their CBOE stakes, which could postpone the merger.

But CME members are confident it will go through as planned.  “From what I understand, the CBOE lawsuit is being worked out at the present,” said WexTrust Capital fund manager Paul Adrian, who uses the CME to trade his own futures account.  “It should be settled in time before the merger takes place.”

Regardless, the Merc and CBOT say they will reserve $15 million to fight the case if it continues after the closing of the merger.

So, after the merger, what’s next for the CME?

Some analysts speculate that the Merc will eventually buy the CBOE, which is estimated at $1.8 billion. “Acquisition is part of the plan,” said Adrian.  “But I’m not sure if the CBOE is.”

So will the CME arrange another “merger made in heaven”?  Investors will just have to wait and see.

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