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CME Upped to Neutral

Zacks Equity Research

Based on our optimism about the index business opportunity from CME Group Inc.’s (CME) joint venture (:JV) with McGraw-Hill Cos. (MHP), we have upgraded our recommendation on the former to Neutral from Underperform. The JV should improve CME Group’s operating leverage, while also offering it the benefits of diversification.

However, we remain concerned about the volume growth, owing to the ongoing macro-economic volatility.

CME Group reported its first-quarter 2012 operating earnings per share of $4.02, which stood at par with the Zacks Consensus Estimate, but lagged the year-ago quarter’s earnings of $4.36 a share. Lower volumes, clearing and transaction fees and higher operating, non-operating and tax expenses deteriorated the top line and margins. However, rate per contract improved marginally.

CME Group’s diversified product portfolio is significantly exposed to extreme interest rate volatility, strict government regulations and limited credit availability. Moreover, the trading activity is inherently variable, both seasonally and cyclically, whereas many of CME Group’s costs are fixed. The regulatory reforms implemented in the exchange industry have also exposed the company to severe competition.

The lingering weakness in derivative markets and widening of spreads are also nibbling into the top line and earnings of CME Group, which witnessed a year-over-year decline in the first quarter of 2012, even as operating margin fell below the 60% benchmark after several quarters. The near-term outlook appears grim and may continue to dampen the company’s operating leverage until the derivative markets gain traction.

However, recent acquisitions, alliances and divestments bode well for CME Group’s long-term growth. The company continues to execute its global growth strategy in the key emerging markets of Europe, Asia and Latin America.

Going forward, the successful launch of S&P-Dow Jones Indices under the CME Group-McGraw Hill JV will help CME Group to tap about $6 trillion of assets that are benchmarked against the leading Dow Jones and S&P indices, thereby generating ample revenue potential.

Alongside, the company’s own initiatives to outgrow and reach out through the launch of new over-the-counter (:OTC) products and technological innovations such as CME Direct, Swapstream, BM&F and FXMarketSpace are also supporting volumes across CME Group’s entire product spectrum. We expect this increasing trend to bear fruit in the long run along with substantial leverage from over 200 products launched in 2010, 2011 and so far in 2012.

Hence, based on the pros and cons, the Zacks Consensus Estimate pegs earnings for the second quarter of 2012 at $4.09 per share, which is about 6.5% lower than the year-ago quarter. Of the 14 firms covering the stock, five revised their estimates upward in the last 30 days, while one downward revision was witnessed.

Currently, CME carries a Zacks Rank #3, implying a short-term Hold rating, in line with the long-term Neutral recommendation.

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Read the Full Research Report on MHP

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