Many investors have an investment ‘strategy’ in which they create a portfolio of dividend-paying stocks. Investors typically use a stock screener and amend the ‘dividend yield’ parameter to identify potential investments. Stock screeners, however, have shortcomings. CME Group (CME) is a unique dividend gem often excluded from a stock screener’s output yet it might meet the search parameters.

CME Group – A Unique Dividend Gem

Business Overview of CME Group

CME Group (CME) traces its founding back to 1898 and conducted an IPO in 2002. The firm acquired CBOT Holdings in 2007 and changed its name from Chicago Mercantile Exchange to CME Group. The firm also acquired NYMEX Holdings in 2008, Kansas City Board of Trade in 2012, and NEX Group in 2018. Today, CME Group offers markets, trading, and clearing in derivatives, futures, options, cash, and over-the-counter (OTC) products. The firm also offers data, analytics tools, and research to customers. The firm had $4,870 million in revenue in 2020. The best way to learn more about CME Group Inc. (CME) and its competition is to review ‘Item 1 – Business’ that starts on page 5 of 100 in the FY2020 10-K.

Financial Review of CME Group

Q4 and FY2020 Results

CME Group released Q4 and FY2020 results on February 10th and held its analyst call

FY2020 was a challenge due to low volatility in several asset classes. Encouraging signs with some of CME Group’s higher rate per contract products, however, was witnessed. The metals line of business also had its 5^th consecutive year of record annual volume and 2021 is off to a good start. Very strong activity was also evident in the agricultural commodities line of business in Q4.

CME Group’s improved revenue in Q4 might be a sign that revenue may have stabilized after a fairly volatile year. The company reported net income to common shareholders of $0.424 billion, or $1.18 per diluted share, on $1.1 billion of revenue in Q4.

Revenue increased ~1.6% from the previous quarter but was down ~3.5% year over year. This is because CME Group is more exposed to asset classes that are cyclically depressed, including interest rates and energy.

Interest rate product trading will likely remain depressed. Secondly, energy trading is likely to recover along with the economy. Thirdly, equity index derivative trading will likely modestly decline but remain higher than pre-2020 levels.

Less hedging or speculation is occurring in CME Group’s interest rate futures given the current low short-term interest rate environment. Furthermore, the likelihood is rates will remain low until 2023.

In the 2^nd half of 2020, energy prices were somewhat range-bound after recovering from the COVID drop in the first half of 2020. More effective vaccines and an improvement in the vaccination rate may lead to a better than previously anticipated recovery in the economy and demand for oil.

On the equities front, there was a resurgence in retail investor interest in equities in 2020. This led to equity index derivatives volumes being ~60% higher than in 2019. I don’t know if the retail trading activity will abate. The increased popularity of $0-commission trades at retail brokerages, however, has undoubtedly led to a permanent increase in retail engagement.

On the plus side, CME Group has assembled a diverse set of derivative products in:

• interest rates;
• equities;
• commodities;
• metals; and
• foreign currency.

Weakness in one product is often offset by strength in another. CME Group also stands to benefit from rising volatility; trading volume should increase thus leading to increased revenue.

On the downside, there is always a risk that deregulation could result in customers avoiding the clearinghouse model.

Free Cash Flow (FCF)

In fiscal year 2020, CME Group generated ~$2.5 billion of free cash flow versus $2.4 billion, $2.3 billion, $1.8 billion, $1.7 billion, $1.4 billion, $1.2 billion, $1.2 billion and $1.1 billion in FY2019 to FY2012. This steady improvement in FCF gives management more flexibility to meet:

• annual mandatory capital expenditures;
• debt repayment;
• dividends;
• share repurchases.

Financial Guidance

CME Group had initially targeted $0.11 billion in run-rate synergies by the end of 2020 related to the NEX acquisition. By year-end, it had achieved a total of $0.14 billion in synergies net of additional costs incurred to run parallel infrastructures as the company continues to work on the migrations to Globex. On the Q4 earnings call, management reiterated its commitment to its $0.2 billion annual run-rate synergies target by the end of 2021.

Fiscal year 2021 adjusted operating expenses excluding license fees are expected to increase slightly from the low 2020 levels to $1.575 billion.

On the capital expenditures front, excluding one-time integration costs and net of leasehold improvement allowances, management expects to spend ~$0.18 billion to ~$0.19 billion. The fiscal 2021 adjusted effective tax rate is expected to be 23.2% – 24.2%.

On January 12, 2021, CME Group and IHS Markit announced the formation of a leading ‘Post-Trade Services Joint Venture for OTC Markets‘. This joint venture will be a leader in trade processing and risk mitigation services and will offer the combined clients complementary services across the global OTC marketplace in interest rate, FX, equity and credit asset classes.

Interestingly, S&P Global announced in late 2020 its intent to acquire IHS Markit.

Risk Assessment

A schedule of CME’s long-term debt and related interest rate swaps is found on page 69 of 110 in the FY2020 10-K.

The major credit rating agencies undertake a comprehensive review of a company and assign a risk rating. I use these ratings to gauge if my risk as an equity investor is reasonable.

Moody’s rates the unsecured long-term debt Aa3, S&P Global rates it AA-, and Fitch rates it AA-. All ratings are stable and are the lowest tier of the high-grade investment-grade category. These ratings indicate CME Group has a VERY STRONG capacity to meet its financial commitments.

The current ratings are satisfactory for my risk profile.

Dividends and Dividend Yield

Go to go to the stock screener you generally use. Select the USA as the Country, Market Cap above $10 billion, and select 1% in the Dividend Yield field. Based on the current ~$205 share price, CME will appear in the search results. Repeat this process with 2% in the Dividend Yield field. Now, CME does not appear in the search results.

If you look at CME’s dividend history, however, you will see CME declared $5.90 of dividends in 2020. This is a ~2.9% dividend yield based on the current ~$205 share price. This is because of a variable dividend policy introduced in 2012. The policy stipulates that excess cash is swept to shareholders in the form of a ‘special dividend‘. It is declared in the first half of December and is distributed in mid-January.

I look at a company’s dividend CAGR to see if the dividend growth rate outpaces the rate of inflation. In the case of CME Group, the $0.05/share quarterly dividend increase from $0.85 to $0.90 per share is a ~5.9% increase. This outpaces the rate of inflation. I also know it is only one component of the company’s overall dividend.

Let’s look at CME Group’s dividend CAGR.

CME has consistently increased its quarterly dividend over a prolonged timeframe. The stock is a Dividend Contender. The ‘special dividend’, however, does fluctuate. This explains the huge swings in the company’s annual dividend growth rate and it is difficult to determine the forward dividend yield. The chart from StockRover* illustrates the dividend growth.

Source: StockRover*

Let’s presume CME Group declares another $2.50 ‘special’ dividend in December. The $0.90/quarter dividend and the ‘special’ dividend would amount to $6.10 or a ~2.9% dividend yield based on the ~$209 share price. If the share price drops to my recommended ‘buy below $175’ price, the dividend yield is ~3.5% or better.

Share Repurchases

On a shares outstanding basis we see that in the FY2011 to FY2020, the weighted average number of diluted shares outstanding (in millions) has increased: 334, 332, 334, 336, 338, 339, 340, 344, 358, and 359.

Valuation of CME Group – A Unique Dividend Gem

I first wrote about CME Group on August 5, 2018, when shares were trading at ~$162. At the time, the forward adjusted diluted P/E was ~24.2.

In my February 15, 2019 article, CME Group’s valuation was reasonable but I envisioned a share price pullback that would make shares more attractively valued. This ‘wait and see’ tactic somewhat backfired but when I revisited CME Group in my June 29, 2020 article the share price has pulled back to the point where the forward adjusted diluted P/E was ~21.5.

On the February 10, 2021 FY2020 analyst call, management did not provide fiscal 2021 adjusted diluted earnings per share guidance. I am, therefore, guided by fiscal 2021 analyst estimates.

Guidance from 21 analysts calls for fiscal 2021 mean adjusted diluted EPS of $6.72 with a low/high range of $6.06 to $7.59. With shares currently trading at ~$205, the low/high adjusted diluted P/E range is ~27.54 to ~34.5 and ~31 if we use the mean level. This level is high relative to historical levels (FY2011 to FY2020: 12.92, 18.77, 27.53, 29.45, 24.22, 26.89, 33.12, 14.20, 35.28, and 30.34).

Conclusion CME Group Is A Unique Dividend Gem

If you overpay for an investment, the return on investment has a strong probability of being sub-standard. Many investors, however, overlook valuation. Do not follow the ‘herd’.

I acquired 300 shares on August 7, 2018 at ~$161.94 and 300 shares on June 29, 2020 at ~$162.13. In both instances, shares were reasonably valued. CME Group’s current valuation, however, is elevated.

CME Group is a unique dividend gem but I am not acquiring additional shares. I am patiently waiting for shares to retrace ~$175 or lower. At this level, and using the fiscal 2021 mean adjusted diluted EPS of $6.72, the forward adjusted diluted P/E is ~26. This is acceptable.