CME Group Inc. (CME) Earnings Call Transcript & Summary

All right. We will go ahead and get started. Thanks, everybody, for joining us this morning. I am Patrick O'Shaughnessy, Capital Markets Technology analyst here at Raymond James. And up next, we have CME Group. And on CME's behalf, we have at the far end, Jack Tobin, Chief Accounting Officer; in the middle Tim McCourt, Global Head of Financial and OTC Products; and Adam Minick, Head of Investor Relations. So thanks for joining us today. So Jack, I'll kick things off with you. We tend to have a lot of generalists and PMs in the room. So I'll ask that you please kick off the discussion with a brief description of the company today. And for -- add a context, how that compares to what CME looked like 5 years ago.

Great. Thank you, and good morning, everyone. For those who don't know, CME Group, we are the world's leading global derivatives exchange. We offer products and tools for the marketplace to both manage risk in whatever the environment is and also to capture opportunities in those markets. We have extremely deep pools of liquidity in all of the major asset classes today, from interest rates, equity, energy markets, FX, agricultural markets and metals markets. With the last really pure-play derivatives exchange the last major one, I would say, we have an extremely strong business model. Our current operating margin on an adjusted basis is about 67%, which is pretty unheard of. We've also have a very generous dividend policy, which I think has been very much appreciated by our shareholders and has served us well over the years. And finally, we've -- going into the Q4 of last year, we've experienced 10 consecutive quarters of double-digit earnings growth. So we're pretty proud of that record. And then for more recent activities in the past 5 years. I'll just turn it to you, Tim.

Great. Thanks, Jack. So it's interesting when we look at the last 5 years, certainly, a lot of things have changed about the business, the market and the industry. But the one thing that's been consistent is the growth and innovation that we see at CME Group. And it's not something that is just necessarily driven from our strength as a U.S. exchange. We've actually seen very strong growth internationally when we look at 2019. Our international volumes are up about 50% for that, doing between now 7 million to 8 million contracts per day. And also similarly, when we look at our options portfolio, where at CME Group, we have options on futures, that has also continued to become more and more important in terms of the risk management of our clients. Where about 5 years ago, we were doing maybe 4 million option contracts a day. So last year, we did about record 5.1 million contracts and options per day. But already, the first 2 months of the year, we're doing almost 6.4 million option contracts a day. So I think it's important to note that despite being almost a 200-year-old futures exchange, we're actually innovating in options, OTC alternatives, growing our sales force and product presence internationally. We're -- just to note, for example, about 2/3 of our sales force at CME are based outside the U.S. So really trying to tap into that international growth that we're seeing across the financial markets. And then also when we look on the product innovation, I think, over the last 5 years, some of the things that stand out are the advents of micro contracts at CME Group, or option growth that I talked about. We also completed the NEX integration. We've also entered the partnership with Google Cloud. And when we look at it, it's something that we continue to innovate. And I would say, 5 years is a good period. But if you actually look back several decades at CME, we have a long-standing tradition of innovating in products and sometimes they are successful right away like the micros or sometimes they're out there for a few years. And then in -- part of that portfolio, when the market cooperates or risks manifest, we have a very wide swath of tools available for the marketplace to manage their risk and only increasing uncertain times.

All right. Terrific introduction. Thank you. Adam, what do you think investors who are new to the story, don't appreciate about CME in the way that you most informed shareholders do?

Thanks, Patrick. It's a good question. A few different things come to mind. First of all, Jack mentioned earlier the breadth of our asset classes. I'm not sure if it's readily apparent to our investors that this diversity really helps us to grow in all different kinds of market conditions. So if there's an environment where one asset class is down in a given year, it's likely that others are going to be up. And that's one of the reasons why over the past 50 years, there have only been a handful of times when our volume has actually decreased from 1 year to the next. Another thing that I think may not be readily available apparent to investors when they first look at our business is they see that roughly 80% of our revenue comes from transaction and clearing fees. But it may not be apparent that there's a recurring nature to much of that business because many of our customers are participating in our markets day in and day out and hedging their risks as a part of their day-to-day business operations. And so that revenue, while it is transactional in nature, it's more consistent and recurring than might be at first glance. Finally, I think there's some misperceptions in the market today around how CME is positioned in the current interest rate environment. But for that, I'll turn it over to Tim McCourt to talk in more detail.

Great. Thanks, Adam. I think one of the questions we get from clients, from investors is with the macroeconomic backdrop that we're currently operating in, is this as good as it gets for CME. And from our perspective, it is not. So when we look at it, think about the world we're operating in, where there's this tension between macroeconomic policies, geopolitical events, market fundamentals with respect to GDP and all of these things are playing out. But if you look at interest rates specifically, sure, conventional wisdom might suggest that in a rate-cutting environment or an expected rate cutting environment on the horizon, that our volumes might come in a little bit. There might be a bit of a meaner reversion. But the one thing to remember is that you can't apply conventional wisdom in unconventional times. So when we look at the markets in front of us, if we look at the FedWatch tool at CME Group, even though the market starting in June is sort of unilaterally agreed in the direction of rate policy with rate cuts, the market is vividly disagreeing on the size and the speed of those cuts. And that's very good for our volume as people are looking to constantly rehedge that with the futures as well as the options complex and they're looking to be very precise about a function of time and strike they're looking to manage that risk. And to put that in perspective, if we just go back a few weeks, the week of February 12, we had, what, 3/10 of our divergence in the CPI numbers that were released. And then the expectation of Fed pausing went from 38% to about 78% now with the May meeting. So just because of that one news, we had a complete flip in the market expectation of the May action for Fed policy and the exchange volume, I think, did 35 million contracts that day. So I think that's just a recent example when it doesn't take much to remind the market that the risks are out there, they need to hedge against them, and it's going to present opportunities for both opportunistic trading as well as increased risk management.

Jack, what is difficult for competitors, either existing firms or future start-ups to replicate about CME's business?

Thank you. So first, I mean, we have a healthy respect for competition. So we don't take anything for granted. But there are a few aspects of our business that are very difficult to replicate in the marketplace today. Particularly, we have -- as I mentioned, we have all the major asset classes that we -- we offer all the major asset classes. We have very deep pools of liquidity in each of those asset classes. So by definition, we have very tight bid-ask spreads in each of those marketplaces that make us the logical place for participants to play in the markets would be in our markets because the true cost of trading is really a function of the bid-ask spread. Our fee is a very modest portion of the overall cost of trading. That bid-ask spread being as tight as possible is what gives us the power that we have today. And it's very difficult to replicate that. It's also difficult to replicate the margin advantage that we have today because we have folks with open interest today in our products, who require margin. And if they take positions in other products that are correlated to those, we offer cross-margining where we can minimize the capital that they have to put up trade in our markets. Now that makes us enormously efficient place for market participants to come to, again, participate in the market. And again, very difficult to replicate, not something that we take for granted. We stay on top of it every day, but we enjoy those advantages, and it's frankly very difficult to replicate.

So Adam, you earlier spoke to, there's kind of a recurring nature to your volumes and maybe people don't fully appreciate. But there's also some volatility to trading volumes as well. You can have really big days like you had in February. You can have some slower days as well. So volatility is just kind of inherent in the business model. Maybe Tim, this is a question for you. How do you guys manage the business to kind of be cognizant of the volatility, but not be overly reactive to it?

Yes. Its a great question. And I think the one thing to remember is that the risk that people need to manage is only increasing over the last few years so when we look at running the business and product innovation it's a balance of making sure the market operate as efficiently today and we're unlocking those capital efficiencies in margin savings that Jack was alluding to that were maintaining the efficacy of the price discovery process in a transparent and efficient manner at CME group. But on top of that we have to make the investments in the product innovation front to stock the shelves, equip the toolbox, whatever analogy you want, such that they're there when the market needs it most. And I think what's interesting, what we've seen over the last few years, I mentioned the interest rate example. But even in the equity markets, if we look at 2023, the volatility of equity markets came in substantially, I think almost between 30% and 40% versus the year prior. But our volumes did not come in, in the same sort of slope with respect to the volume performance that we saw, and revenues were actually up a little bit for the equity complex. So we have a multitude of strategies where we're making sure the market runs smoothly. But when we introduce products, we're also looking at things like the OTC market. the adjacent markets. And when we introduce products, we make sure that we expropriate the appropriate amount of value at CME in terms of the transaction and clearing fees that we charge versus the alternatives. So when we're going after the OTC market or swap alternative products. Those are premium products in the market that are becoming more and more important. So as the market ebbs and flows in terms of managing that risk, having all of that product choice, all of that asset class choice at various pricing points as a function of the rate per contract we're able to capture is the way we manage the business, but it's really not one or the other. We don't rely on the market, but certainly the market volatility can amplify the volume and the risk management that we're seeing, but we're not solely dependent upon the market performance for the performance at CME.

And then, Adam, following up on that point, CME is coming off the best back-to-back revenue growth years since 2010, 2011. Is there anything about the nature of that growth the last couple of years that gives you confidence in the sustainability going forward?

Yes. So in the first half of last year, we made a comment where we looked back and said, okay, over the past 5, 7 and 10 years, depending on which time frame you choose, we experienced earnings growth of between 10% and 12% per year on average. And yet where we were sitting in 2023, we actually felt like we were better positioned in 2023 than we had been in that prior decade, where we saw that double-digit earnings growth. And part of that was due to a more favorable macro backdrop. Now since stating that goal that we expect to meet or exceed those 10% to 12% growth rates over the coming decade, we're off to a pretty good start. We had 17% earnings growth in 2023. And I think there might remain call it, an under appreciation for how challenging that prior decade was in terms of facing headwinds from things like 0 interest rate policy and quantitative easing and things of that nature that kind of acted as headwinds to risk management.

Tim, when you think of some of CME's biggest innovation successes, what was the process by which they came about in terms of internal development versus working with clients?

Yes. So what's interesting, I would say, broadly speaking, our approach to product innovation at CME Group is that we are demand-driven on the innovative front. We listen to clients and truly try to understand what problems do you currently have, what is missing from your risk management capabilities and how can we work with you to bring that new capability or that new product, that new market structure to bear in a way that is helpful for you and participants to manage risk. So it's something that we're -- at CME is unique in our sales force approach of the more than 100 sales folks that we have across the globe interfacing with clients. And I think also what -- Patrick, what you're saying is it from an internal perspective, the 1 thing to remember about CME is when we look at the product staff or the staff of my division, the staff and the Commodities division, our sales force, a lot of us ourselves are ex practitioners. We are ex clients of CME. It's really marrying our own perspective with the current real-time feedback of market participants and clients to figure out that secret sauce for product innovation. But then you also feather in things like regulatory demand, market structure demand. These all present opportunities. We just recently completed the transition from LIBOR to SOFR. That complex is now out trading the historic Eurodollar complex at CME. So that was a combination of market need, regulatory driven, but it's our ability to work with the marketplace to assess that need and design products at the right time in a right and meaningful fashion that couple all the things clearing, risk management, availability, transparency, global reach. But it's really that demand-driven where historically, I would say we weren't as good as meeting that demand, and we're much more prudent and judicious with our resources to make sure we're focusing at the right time to meet that right demand as articulated by the marketplace.

Adam, during your interactions with investors and I think particularly your biggest long-term investors, not to necessarily spill any secrets, but what are they asking of CME Group? What do they want you guys to do? And then what do they not want you guys to do?

Yes. So Tim spoke earlier about some of the misperceptions currently facing our interest rates business. I think what many of our investors want to see today is they want proof that we can continue to grow in the current interest rate environment. And I think where the challenge is, we haven't seen what I'd call a normal rate cycle in decades. We haven't seen inflation like we have today in decades. And so it's a little difficult for us to point to clean historical parallels to say, CME should perform really well in this environment because it looks like year X, Y or Z. Now the good news is, I think we're starting to build a track record of growth in this environment. So in the 7 months since the Fed stopped raising rates, our interest rate volume is up 21%, and that compares favorably to the 11% year-over-year growth we saw in the first half of last year, during which time there were actually 4 rate increases by the Fed. And so we are starting to prove that out, but I think for some investors, that's going to take time. On the flip side, what do investors not want us to do I think there are a few things that investors really value about CME. So 1 of them is our ability to demonstrate expense discipline without compromising our investments in growth. Another one is the consistency and transparency of our capital return policy that Jack talked about earlier. And then another 1 would be the discipline that we've shown when it comes to M&A. I think if we were to make a change to our approach in any of those areas, it would require a pretty good reason as to why that change is going to enhance shareholder value.

So Jack, CME clearly has a very high bar for acquisitions. The company has only completed one major acquisition since buying NYMEX in 2009. In contrast, most global exchange groups have been highly acquisitive during that period of time. Why do you think CME's capital allocation strategy is so distinctly apart from peers?

Yes. Well, first, just some backdrop. The CME Group was very early to the game in terms of the consolidation of the derivatives space. Acquiring the Chicago Board of Trade back in 2007 and then subsequently NYMEX exchange in 2009. Those 2 -- and COMEX is part of that as well. Now, those acquisitions really cemented CME Group as the primary owner of the meaningful asset classes in the derivatives space. Since then, any potential acquisition opportunity clearly comes across our dashboard to take a look at. And as you mentioned, we've been highly selective. I would separate it from our sort of capital allocation comment. I'd be only because our financial strength is really strong, right? We have less than 1x debt to EBITDA and AA- rating on our long-term debt. I mean we have enormous financial capacity. That's not really the constraint. On the capital side, on our dividend policy, it's just one of those things that's been very transparent and very rewarded by the marketplace over time. Since 2012, our dividend policy, we paid out $24 billion in dividends. Our approach is essentially to pay out roughly half the year -- the prior year's cash earnings as part of our regular dividend. And then at the end of each year, we have kind of a unique structure. We call it our annual variable dividend where we pay out excess cash over and above what we currently anticipate as our cash needs. And over time, again, that's added up. Our shareholders very much appreciate that transparency. And in the event that there are opportunities where we need to curtail that annual dividend. We've done that in the past, and our investors have accommodated that.

So Tim or Adam, this question is probably for either one of you kind of getting back to the topic of innovation. What are the innovations that are either underway or you've recently brought to market that you guys are particularly excited about right now?

Yes, sure. So I think there are a few ones that are in flight or recent. And I'd say, some of the ones I'm excited about are in the interest rate complex, right? I had mentioned a few minutes ago, we were previously really focused on the transition from LIBOR to SOFR. Now that, that is behind us, one, it's important to know that it's really the start of the SOFR story at CME. We're also working to introduce CME term SOFR in terms of more and more adoptions to the marketplace. But around the gravity that SOFR provides and our treasury complex provides, we're introducing additional risk management tools whether that be T-bill futures, TBAs, Ester as well as our recently announced partnership with Bloomberg to bring corporate credit index futures to the market. These are all things that are adding different parts of the interest rate ecosystem to the already market-leading ecosystem that we have at CME Group. So that's one thing I'm excited about. You also look at the developments we're doing on the options on futures front as well as market structure in both the rates as well as the equities market. That is something that I'm excited about because we're working with market participants, as I was saying earlier, to increase or evolve market structure to meet more of their risk management needs and bring more of that sort of upstairs or off-exchange OTC trading to the exchange, the centrally list, centrally cleared market at CME. So we're also continuing to innovate on the market structure front, work with the regulators to introduce additional order types or transactional handshakes to increase the speed at which market participants can transfer and manage that risk. Then we also look across the FX asset class. One of the things I'm really excited about what you've heard us talk about is CME FX Spot+ . This is something that we're bringing together the spot market and the futures market at CME, which we are uniquely positioned to do in the marketplace given the assets that we have in our portfolio, such that we can actually transpose the pricing from each of those centers of price discovery into the other product type. So we have the ability to bring additional spot currency payers based on futures market to the legacy EBS community and vice versa. We can avail spot-based pricing into those that prefer futures format. This is something I'm excited about both on the technology front is really a real proof positive of this is the value that we saw bringing the cash to futures markets side by side. And we're looking forward to getting customer testing online later this year. And just I'd be remiss not to say one of the things that is certainly having its moment in the sun right now is cryptocurrency. About 6 years ago, we entered the cryptocurrency market, we've remained steadfast in our ability to introduce additional reference rates and additional products. And with the spot ETF being approved back in January, we're certainly seeing increased risk management, increased ecosystem development. And that's something that I'm excited about across all of our asset classes that we operate in a highly interrelated ecosystem of which CME Group is at the center of most of it in all of our asset classes. So when you think about that leading the price discovery process leading the capital management and efficiencies and clearing that Jack alluded to earlier. When you combine all of that, that really puts us in a unique position to drive innovation and push out that frontier of risk management to the benefit of all market participants.

And I'll just add on. There's clearly a lot of innovation happening on the financial side of the business, but we're also continuing to innovate on the commodities front. And so 1 example would be with our environmental products portfolio. And this is another one where CME is pretty uniquely positioned back to the first comments we made about the breadth of our asset classes as the only exchange out there that really has metals, energy and agricultural products under one roof. We're kind of entering a stage where a lot of these new environmental products don't fit cleanly into any one of those buckets. So take things like battery metals, like cobalt and lithium, are those metals? Or are they energy products? But because we have all of those customers in under one roof, it doesn't really matter where we classify them because we have the right customers there to trade those products. You can make the same argument about things like biofuels. We're also doing a lot of work in the voluntary carbon market. Now none of these things, I would not expect these to be major drivers in 2024, but I'd be willing to bet that in 2034, the environmental products are going to be a much larger part of our portfolio.

All right. Terrific. We have about 5 minutes left. So I will pause and see if there's any questions in the audience.

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Yes. So the most recent examples would be times like where you enter a major risk off environment. So take something like the financial crisis where see a big spike in volume initially. But then the next year, as open interest declines, you'd see lower volumes. Similar things happened at the onset of COVID. And sorry, for those on the recording, the question was around examples of times when volume may have decreased from one year to the next.

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Sorry, what was the last part of that question?

[indiscernible]

Yes. So the question was sort of on the international growth front, what are some observed differences in the international markets perhaps versus the U.S.? And how are we positioned to capitalize on that international growth? And I would say the one thing is that our model scales very well across the globe. We're a relatively lean organization in terms of total headcount. And when we look at sort of the commercial side of the organization, we have a mix of both global model on the product side where our teams are run globally. And then on the sales side, they're regionally adapted by customer segment and geography. So it's a powerful combination of the 2 to marry the subject matter expertise of the product side with the local knowledge on how to sell that product to meet that customer demand. And what's interesting is largely, I would say, the customer personas or personality are fairly congruent with respect to maybe how the buy side, sell side, the retail segments are operating across the globe. So the fact that we are designing products that are universally applicable, that is something that really plugs and plays well with the international growth. The one thing I would actually point out to, is when we see some of the international participation in our markets, we tend to be the international leader from a non-U.S. perspective where we may not be necessarily the leader in the U.S. And a perfect example about that is our E-mini equity on options. Admittedly, we are not the incumbent from a U.S. trading hours perspective, but that share ratio completely flips when you look at non-U.S. hours. And we have over sort of 75% of that share when looking at a non-U.S. trading perspective because CME was a pioneer on making our markets available nearly 24 hours a day, Sunday night through Friday afternoon from a U.S. perspective. We've been in the global trading game for decades and others are just starting to introduce it. So the trust, the transparency and our physical commitment in terms of staff is something that differentiates us. It actually makes it very easy to tell our story because it is universally appealing benefit from the centrally cleared centrally trade markets at CME regardless of what geography you might be in.

All right. Terrific. I think that's a good spot to end, but thank you guys very much for joining us.