The revelation that NYSE Euronext and Deutsche Börse are in advanced merger talks was not exactly welcomed in Chicago, the home of the US’s listed derivatives market.
Terrence Duffy, executive chairman of CME Group, told reporters in Chicago that he was concerned that the combined entity could have their derivatives and stock trading businesses “eventually moved to overseas territory”, which could help it evade US Dodd-Frank reform rules. “That’s a big deal,” he said, according to Reuters.
However, he also said that “we positioned ourselves exactly because we could anticipate this coming down the pipe”. He added: “I like the place the CME is in right now.”
A merger would combine NYSE Liffe and Eurex – the futures arms of NYSE Euronext and Deutsche Börse respectively – creating a market that would overtake Chicago-based CME Group as the world’s biggest futures exchange.
It would also bring together the two US equity options-trading platforms operated by NYSE Euronext with Deutsche Börse’s International Securities Exchange, forming by far the biggest options exchange group in the US and swamping the Chicago Board Options Exchange, the US’s first and until recently its biggest options-trading venue.
But it is in futures that the deal would be more of a game-changer. “This merger is a big headache for the CME,” says a former CME senior executive. “Separately, each of these companies is a formidable competitor. Together, they will be even more formidable.”
Even before news of the NYSE Euronext-Deutsche Börse discussions broke on Wednesday, there was a cloud hanging over CME, after the company revealed last week that rising costs in 2010 eroded the benefits of increasing revenues, a trend that is expected to continue this year.
While CME has not kept its investment in a string of new ventures a secret, the extent of the outlays – pushing profits down below expectations – apparently wrongfooted Wall Street analysts, who rushed to lower their profits forecast and share price targets.
“If you were to tell us at the beginning of 2010 that CME would grow its revenue 16 per cent organically but see its operating margins contract, we would have said you were nuts,” Patrick O’Shaughnessy, an analyst at Raymond James, wrote in a research note. “The operating leverage of the firm’s business model should easily translate 16 per cent revenue growth into 20 per cent-plus earnings growth.”
Expense growth outpaced the rise in revenues in the fourth quarter, pushing down net income from $203m to $196m and operating margin dropped from 60.3 per cent to 60.1 per cent.
While most of those costs were accounted for by higher compensation expenses – bonuses nearly doubled from 2009 to $72m – CME this year expects costs to rise by $110m to $1.26bn, with half of the increase due to investment in new ventures.
One such initiative is a “co-location” facility in the Chicago suburbs, allowing traders to place their computers next to the exchange’s trade matching engine, slashing trading times. They also include plans for a multi-asset trading platform that CME is developing with BM&FBovespa, the Brazilian exchange, clearing over-the-counter (OTC) derivatives and a European clearing house.
The problem is that none of these ventures will start to pay off materially until at least next year. “2011 is shaping up to be a relatively lacklustre year for CME Group,” Mr O’Shaughnessy observed.
CME management says the initiatives are setting the foundation for long-term growth, but not everyone is convinced that revenues will overtake the extra cost burden in the foreseeable future. Roger Freeman, an analyst at Barclays Capital, has warned of “the potential for CME’s expenses to trend higher as the company travels further down the path in growing its new initiatives (primarily OTC clearing)”.
Moreover, there is uncertainty about how profitable the initiatives will be, prompting some observers to ask whether the company has overextended itself.
Clearing interest-rate swaps, for example, depends on attracting the big banks that are the main dealers in the contracts. The CME scrapped a previous attempt to establish a trading platform for credit-default swaps after failing to garner dealer support.
Even if CME were able to get the dealers on side, it is not clear that clearing OTC transactions will become a significant source of revenue, and building volumes could take several years.
In recent years, CME has grown through big exchange acquisitions, such as its $11.6bn purchase of the Chicago Board of Trade in 2007 and a deal to buy the New York Mercantile Exchange for $7.6bn in 2008.
But some say it now lacks a coherent strategy – a deficiency that a NYSE Euronext-Deutsche Börse merger could expose. “They became fat and happy, and now it’s pretty clear that they don’t have a game plan,” says the former CME executive.
Few, however, are betting against the company in the longer term. Analysts seem convinced that CME is setting the stage for long-term growth and most are still bullish on the company. Mr O’Shaughnessy, for example, expects “the business likely to improve much more sharply in 2012”.
Meanwhile, likely rises in the cost of energy and other commodities will drive volumes in CME’s core business this year, while interest rates could start to rise next year, driving growth in Treasury futures.
However, a NYSE Euronext-Deutsche Börse merger would add new heft to a significant challenge to CME’s near-monopoly in US Treasury futures, as NYSE Euronext readies its own clearing house for US Treasury futures. That could erode CME’s ability to raise fees in its traditional business, even if costs continue to rise fast.
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