Are CME Group Shares Still a Good Value?

Financial market trading is mostly done online these days, with physical pits -- where enthusiastic traders yell over each other -- slowly phasing out. A few do still exist, and one of the biggest operators is the CME Group (CME 2.89%), based in Chicago. The company runs the largest derivatives marketplace in the world, where investors can access futures and options contracts on thousands of underlying products. CME Globex, the online portion of the business, accounts for around 90% of total volume. 

These financial instruments are popular with market participants because they usually offer leverage -- the ability to borrow money to increase potential returns (and losses) -- making it easier to build big positions, as you don't need to front all the money. However, according to the company's results, use of these products may have peaked 12 months ago, and many of its financial metrics are now struggling to grow. 

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Shifting trends

CME Group's biggest product line by volume is interest rates, where it offers futures and options contracts on several benchmark products, including government bonds and the federal funds rate. Over the last 12 months, interest-rate-related products accounted for 30% to 50% of total volume in any given quarter. It has been down since Q1 2020, as volatility subsided relative to the wild moves during the early stages of the pandemic.

Since CME's revenue is derived from trading volume, it doesn't matter too much whether interest rates are rising or falling. However, when there are big shifts in expectations, investors tend to make the biggest adjustments to their portfolios. For example, with the Federal Reserve expected to start making monetary policy changes soon, CME might see a lift in activity in interest rate markets.

Volume on energy derivatives also peaked in Q1 2020, around the time oil prices went to zero, and then negative. By comparison, in Q1 2021, volume was down almost 27% year over year. 

These drops coincide with more muted market activity, and also show up in the earnings of key brokerages like Interactive Brokers, which also appears to be losing some momentum after a record 2020. 

Stagnant financial picture

CME Group's total revenue appears to have also topped out in Q1 of 2020, amid peak pandemic market volatility -- where the company would have earned the most fees. They climbed slightly in Q1 of 2021, but still remain about 18% off those highs.

DATA SOURCE: COMPANY FILINGS 

Average rate per contract, which is the average amount CME earns for each derivatives contract traded, fell to the lowest level in 12 months in the recent quarter. The significant uptick in daily volumes allowed revenues to grow on a sequential basis, but volume is also 19% off the peak set last year. Overall, all of these key metrics were down year over year, and the next two quarters will provide insight into whether lower peaks will result in lower lows, too. 

Financial market activity tends to be cyclical, meaning some parts of the year are busier than others. The first quarter is usually the most active, as investors adjust positions at the beginning of the new year -- but also ahead of the spring and summer seasons, when many market participants are taking time off (or planning to). For that reason, the middle of the year tends to be the quietest, and these trends are reflected in CME Group's revenue and volume figures. 

Zooming out, on a yearly basis the company's revenue has grown an average of 8.2% per year between 2016 and 2020. Growth was flat in 2020 (albeit at an all-time high), as the open outcry pits were closed, so about 10% of total daily volume was potentially lost -- although some might've migrated online. Given the Q1 2021 result, it looks like sales might actually contract this year, as CME heads into the quieter part of the year on the back foot compared to Q1 2020.

Looking for value

Despite these results, the stock was trading just below its all-time high at Monday's prices. With $5.33 in trailing 12-month earnings per share, it trades at a multiple of 41 times -- but last time the share price was at these levels (January 2020), the multiple was about 36 times. Therefore, it's more expensive today, even though the company is earning less, and revenues are hovering around the same levels.

Interest rates are lower today than in 2019, and generally, the broader markets are trading higher. But investors will have to consider whether they want to pay the current valuation given historically, upside appears limited from here.

In reality, the market will need bouts of increased volatility to boost CME Group's trading volume, and therefore its earnings, from here. The more likely scenario, though, is the continued sideways movement in the company's key financial metrics.