芝加哥商業交易所 (CME) 2006 Q3 法說會逐字稿

Good day, everyone, and welcome to the Chicago Mercantile Exchange third quarter 2006 earnings release. As a reminder, this call is being recorded. At this time, for opening remarks and introductions, I would like to turn the conference over to Mr. John Peschier. Please go ahead, sir.

Thank you all for joining us this morning. Terry Duffy, our Chairman, will provide a few introductory comments. Craig Donohue, our CEO; and Jamie Parisi, our CFO, will spend a few minutes outlining the highlights of the third quarter and then we'll open up the call for your questions. Rick Redding, our head of Products and Services, is also here this morning and will participate in the Q & A session.

Please note that all references we make during this call to trading volume and [Rapier] contract exclude our low-priced TRAKRS products and our economic auctions products.

Before they begin, I'll read the Safe Harbor language. Statements made on this call that are not historical facts are forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or implied in any forward-looking statements.

More detailed information about factors that may affect our performance may be found in our filings with the SEC, including our most recent quarterly report on Form 10-Q which is available on our web site. Also, we refer this call to our cash earnings, a non-GAAP number. The reconciliation to net income can be found on our web site under investor relations earnings releases.

In addition, we have posted slides associated with this earnings call on the I.R. portion of the site. Now, I'd like to turn the call over to Terry.

Thanks, John. Thank you all for joining us this morning. Before Craig and Jamie discuss our results for the quarter, I'd like to give you a brief update on the recent announcement of our proposed merger with the Chicago Board of Trade. By now, everyone is aware that on October 17, we announced the merger of the CME and CBOT.

We are very excited about the opportunity to create the world's premier derivatives exchange. The combined Company, to be named CME Group, at the time of the close is expected to lead the transformation of the global derivatives marketplace and create operational and cost efficiencies for market users while delivering significant benefits to shareholders. This merger makes terrific strategic sense as it takes us to the next level of the evolution of our business.

Since the announcement, we have met with and spoken to a number of people, including key customers, partners, members, investors, regulators, and government officials. The response has been overwhelmingly positive. We are also pleased to say that during the past week, we filed our merger agreement and we expect to file a registration statement on Form S-4 in the next four to six weeks.

We intend to make the appropriate regulatory filings shortly and we anticipate that our shareholders' meeting will be held in the first quarter. We expect the transaction to close in mid-2007 and we will continue to communicate with our key stakeholders throughout the process. I thank you for listening to this, and I look forward to some of your questions, and now I'd like to turn the call over to Craig.

Thank you, Terry, and good morning. We had another outstanding quarter as we delivered strong results driven by solid execution in our core business. We will keep our call brief today and will provide only the highlights of the third quarter. Our average daily volume was up 28% to 5.4 million contracts per day. Keep in mind that Q3 last year was a tough comparable as we had a period of increased volume during the hurricane season.

Year-to-date in 2006, every product line is growing by more than 20%. We continue to see positive momentum in our options business. Total third quarter options volume averaged 1.3 million contracts per day, up 39% compared with the third quarter last year. Electronic options volume averaged a record 148,000 contracts per day representing 12% of total CME options volume, the highest quarterly percentage on CME Globex to date.

Electronic CME Eurodollar options volume averaged 95,000 contracts per day in the third quarter, which equates to 8% of total CME Eurodollar options volume, up from 7% in Q2 of this year. In the next major upgrade of this system, we plan to add more user-defined spread functionality for options at the end of the first quarter of 2007.

User-defined spreads provide our participants with a high degree of flexibility as they create unique spread combinations.

I want to provide a quick update on a few of the other initiatives. First, the interest and participation level in FX MarketSpace is expanding. In early October 2006, FX MarketSpace announced the second group of institutions that will join our Early Adopter Program. When combined with the participants that had been announced in July, the E.A.P. now includes more than 40 leading financial institutions demonstrating the widespread acceptance of FX MarketSpace among cash market participants.

We now have 16 of the top 20 FX banks in the world including the top five. By joining in the initial stage, these institutions will be instrumental in the development of the offering. They've agreed to commit resources to and participate in the beta and launch phases. This latest group of participants represents key stakeholders across the foreign exchange market including bank proprietary and customer trading desks, as well as hedge funds and other investment managers. In addition, we have continued to make key hires in sales and operations roles within FX MarketSpace.

In early April, we announced our partnership with NYMEX to list their energy contracts on CME Globex, which was successfully launched on June 11. For CME, the addition of energy contracts to the CME Globex platform further diversifies our product offering.

During the second quarter, we averaged 79,000 energy contracts per day. During the third quarter, average daily volume more than doubled to 175,000 contracts. Following the launch of the physically settled WTI contracts on CME globex in early September, we accelerated the electronic volume. Now so far in the fourth quarter, the average daily volume has virtually doubled again to approximately 330,000 contracts per day.

Currently, more than 50% of the WTI volume at NYMEX is electronic and we are trading higher volume electronically than competing WTI offerings. We will continue to work with NYMEX to deepen the liquidity in these products.

In summary, we had another tremendous quarter with significant growth across all of our product lines. As Terry commented earlier, our team remains excited about the CBOT transaction we announced last week. We believe this merger makes a lot of sense and will lead to increased efficiency for our customers around the world in both regulated and OTC derivatives markets. With that, let me turn the call over to Jamie to go over the financials.

Thank you, Craig. We posted another quarter of strong financial results driven by continued volume growth across all product lines. Before I start, I want to point out that the format of our income statement has been modified, which will provide additional transparency. We added a nonoperating category, which includes investment income, the securities lending interest income and expense, and a line for equity and losses of unconsolidated subsidiaries. The unconsolidated subsidiaries line primarily includes our current loss in FX MarketSpace that was previously included in other revenue.

Our total revenue of $275 million for the third quarter was up 22% compared with the same quarter last year. Clearing and transaction fees were up 23% to $217 million versus $176 million in Q3 of last year. Average daily volume was up 28% with impressive growth across the board. Commodities grew 39% versus Q3 of '05. Equities overall were up 32%. Interest rates were up 27% in Q3 and FX rose 26%.

Our average rate per contract excluding TRAKRS was $0.641 in Q3, up from $0.632 in Q2, and down from $0.659 during the same quarter last year. The primary drivers of the sequential rate increase were higher electronic volume which rose from 70% to 71%, an increase in proportion of non-member volume and fewer volume discounts during Q3. This offset the increase in the proportion of our lower priced interest rate volume, which accounted for 59% of the volume in Q3, compared to 57% in Q2.

Within the interest rate product area, the sequential RPC increase was driven by higher electronic volume from Q2 to Q3, a lower well to percentage of options, a higher percentage of the volume from non-members, and higher post trade transactions, primarily exercises, assignments and deliveries. The E-mini increase was driven by positive moves in the non-member volume and lower volume discounts.

Lastly within FX, we saw a higher proportion of the volume from higher priced to privately negotiated transactions, as well as a higher proportion of non-member business.

Moving on to the processing services line, the Chicago Board of Trade reported volume of 3.2 million contracts per day which generated $18.8 million of CME processing revenue for the quarter. In addition, we traded 11 million total NYMEX energy contracts on CME Globex during the quarter with revenue exceeding $5.1 million.

Quotation data fees were $20 million for the quarter, up 7% from $19 million in Q3 of '05. In Q3 last year, our audit assessments were $1.4 million higher than Q3 this year.

I'll take a few minutes to review expenses. Total expenses for Q3 were $118 million, up 11% versus $106 million for Q3 last year, and up from $115 million last quarter. Highlighting a few of the main expense categories. First, compensation and benefits totaled $51.2 million for the quarter, up $3.1 million sequentially. There are three components of this expense, salaries and benefits, bonus, and stock-based compensation.

First, salaries and benefits totaled $37.8 million, up $1.7 million sequentially. This increase was primarily due to an increase in head count, which at the end of the quarter stood at 1,409, up 29 from the prior quarter due primarily to the inclusion of 17 swap stream staffs. Additionally, credits for salaries related to internally developed software were approximately $900,000 lower in Q3 than Q2.

Second, in Q3 of this year, we recorded $8.6 million for the incentive bonus, up approximately $200,000 from Q2 driven by increased cash earnings. The final component of the comp and benefits line, stock-based compensation, totaled $4.7 million in the third quarter, up $1.1 million from Q2 due to our annual stock option and restricted share grant in mid-June. Noncomp expenses totaled $66.6 million in the third quarter, down approximately $800,000 from Q2.

Moving on to the equity and losses of unconsolidated subsidiaries, our proportion of the FX MarketSpace loss was approximately $1.4 million during the third quarter, and there was a small amount related to our one Chicago loss which is more than offset in the other income line based on fees we collect from them. Our pre-tax income was $171 million in the third quarter, up 33% from $128 million in the third quarter last year. This resulted in pre-tax margin of 59% compared to 55% in Q3 of last year.

Net income for the quarter was $104 million and diluted EPS was $2.95. Both of these are up more than a 32% compared to the same quarter a year ago.

Moving on to the balance sheet. At the end of the quarter, we had more than $1.1 million in cash and marketable securities and working capital stood at more than $1.2 billion. Capital expenditures totaled $19 million in the third quarter driven by continued investment in our technology infrastructure to support various organic growth initiatives.

Cash earnings totaled $107 million for the third quarter, up 37% compared to Q3 of 2005 and represented the highest cash earnings quarter in our history.

Now, I will summarize fourth quarter volume to date. We are averaging more than 5.2 million contracts per day so far in October. Interest rate volume is averaging 3.1 million contracts per day. E-mini equities are averaging 1.5 million contracts per day. Equity standard contracts 130,000, foreign exchange 396,000, and commodity contracts are averaging 68,000 contracts per day. Related to our clearing processing agreement with the CBOT, their volume is averaging 3 million contracts per day so far in October.

Lastly, our average daily volume of NYMEX products so far in October is approximately 330,000 contracts. To summarize, we had another solid quarter of performance driven by broad-based volume growth displaying the operating leverage inherent in CME's business model. We are pleased to generate a record amount of cash earnings during the quarter, as cash generation is our primary focus at CME.

Lastly, our entire organization remains very excited about the agreement we announced last week with the Chicago Board of Trade. We will work expeditiously to close the transaction with a focus on delivering the run rate cost savings of more than $125 million. With that, we would now like to open up the call for your questions..

[OPERATOR INSTRUCTIONS] We'll pause for just a moment while we assemble our queue. We'll go first to Chris Donat with Sandler O'Neil.

Good morning, gentlemen, great quarter, there.

Thank you.

First question on your -- with the NYMEX joint venture, or NYMEX -- sorry, NYMEX agreement it looks like about $0.46 per share per contract. Is that a good way to think about it or is the previously discussed range still hold?

Yes, the range we had given before was $0.35 to $0.50 a contract. Obviously, the $0.47 is in that range. We still feel comfortable with that range and we're not prepared right now to update that guidance. We are -- the NYMEX volumes are ahead of where we had originally expected, and we'll be reviewing that in the coming quarter and updating you in January.

When you say volumes are ahead, does that mean specifically October, or fourth quarter or --

The current quarter, yes.

Okay. And in terms of your CapEx, looks like the original guidance was $90 million to $100 million. Looks like you are running well below that plan. Do you expect to come in below plan and does the merger announcement affect CapEx?

The merger announcement isn't going to affect our CapEx for 2006 and we're currently staying with our $90 million to $100 million of guidance for '06.

Okay. I'll get back in the queue here.

We'll go next to Daniel Goldberg with Bear Stearns.

Good morning. It's actually Joel Jeffrey.

Hi, Joel.

Hi, Joel.

Just a quick question. You know, I guess we've heard from a lot of other derivatives markets that, you know, their volumes particularly in their equity related products had been increasing in spite of historically low volatility in these markets. Is that a correct way to think about it or is it more accurate to say it's the use of your sort of equity futures products and options that are keeping volatility low in these markets?

Joel, this is Rick Redding. I think one of the things to focus on in the equity quadrant is these are historically low volatilities. I think you've seen on days when volatility has spikes our volumes are very, very strong.

I don't want to put a cause and effect on it, but our products are actually, when you think about it, used by a lot of these other derivative markets as the underlying products. For example, if you see in the options market, there's a lot of volume. A lot of that volume gets hedged back into our might be E-mini futures product.

One of the things to point out in the third quarter, as well, is in the equity options market, both in our large size, standard size equity products and in our E-mini options, you've seen dramatic growth, which is pretty interesting, and I think it talks to some of the secular changes in the business because we are at very low volatility levels as you pointed out.

Okay. Great. And just one last question. At the analyst day, you guys said you are seeing increased activity from algorithmic traders. Is there a particular product class that you are seeing the most activity in?

In general, we're seeing it in all of the product categories. What you typically see is these algorithmic traders move across FX classes. That's why it's so important ha we have so many asset classes here at the exchange. One market may cool because volatility may dip in that market, they usually pick up their trading volumes in another asset class.

Okay, great. Thanks so much.

We'll take our next question from Christopher Allen with Banc of America.

Hey, guys, how's it going?

Good, Chris.

Just a couple of quick questions on specific expense lines. I saw a big increase in technology maintenance and depreciation and amortization. Just wondering how we should think about those going forward?

On the technology maintenance, there was an $800,000 increase in the expense versus the prior quarter. You know, it was associated with the [electronification] of options, that effort that we're undergoing. Looking forward, we would expect to see, you know, increases in this line as we continue to build our capacity and the related infrastructure and build out the various functionalities. Of course, this is tempered somewhat by our ability to continue to improve on our negotiations with our vendors, as was -- and make our systems more efficient as we saw with the rollout of the Itaniums earlier this year.

Okay. And then on the professional fees, there was basically a $2.2 million decline. Just wondering what drove that and should we expect an increase the next quarter just with some of the acquisition-related fees?

Well, I think the key driver in the decrease from the prior quarter on the professional fees is really the legal fees and other professional fees associated with the prospecting and getting of some of the growth initiatives that we encountered in the second quarter, and we would expect, you know, those included as FX MarketSpace, NYMEX, swap stream and we would expect the fees that are associated with the acquisition or merger of the Board of Trade would be capitalized as part of that process unless, depending on how the FASB ends up coming out on that issue.

Okay. Then just one question on the FX part. Saw a decline in volumes in October relative to kind of September. September, I'm sure, benefited from some roll activity. How would you guys characterize kind of the FX markets right now, what you are seeing in that product class?

One of the things I want to point out in September, that was a record month for us. It was an extremely good month in the foreign exchange markets. What we're seeing a little bit in October is more of a range bound market, especially in the majors. And as energy prices have pulled off here a little bit, you are not seeing some of the disparities and some of the occurrences you are seeing earlier in the summertime. Again, we're looking at October. It's only 23 days into the month, so don't jump to any conclusions.

Thanks a lot, guys.

We'll go next to Don Fandetti at Citigroup.

Good morning, everyone. Good quarter. Craig, I just wanted to get your thoughts, currently, how you see the mix of OTC versus exchange traded products, or that shift over the next few years?

Well, I mean, I think we're going to continue to see more people moving in and out of the two markets together, primary focus that we have is to begin applying some of our capabilities whether it's, you know, trade matching or clearing processing and risk management services to the over-the-counter community.

We're doing that primarily through our FX MarketSpace joint venture with Reuters in the foreign exchange arena, through Swap Stream in the interest rate interest and then through Clearing 360 across a broader array of products over time. That's going to be a long-term effort for us, but we fundamentally believe that, you know, some of the capabilities that we have are very applicable to the over-the-counter market, so we're going to continue to work on that over a multi-year period.

Okay. And do you see any potential opportunities or reasons to team up with maybe some of the major end or dealer brokers over time?

I certainly think that that is a possibility. You know, right now, we've designed pretty well, I think, the growth initiatives that we're focused on, which I just mentioned, as well as, obviously, consummating the transaction with the Board of Trade, and then focusing on the integration that will follow from that. But you know, we definitely think that working with interdealer brokers is consistent with our long-term strategy of helping, you know, facilitate the convergence of the two separate derivatives markets.

Okay, thank you.

And we will go next to Scott Appleby at Deutsche Bank.

Thanks, guys. Nice job.

Thanks, Scott.

Thank you, Scott.

I wanted to try to get a better understanding of your revenue per contract. You did a nice, actually, job of explaining it. What I'm trying to drive at is the non-member revenues. How is the market environment different in Q3 than Q2 which drove that portion higher?

Scott, I'll take a stab at that one. I think it's very difficult to really answer that question. I don't know that there's anything from a macro perspective that is really driving the shift from, you know, member toward a greater level of non-member activity. I don't think there's really a very good answer to your question. I wish I could give you a better one but it's just very difficult to understand what's behind every trade that takes place here.

Okay. Anyone else want to try? [ Laughter ] No?

Not if they have any sense.

Thanks. I'll get in the queue.

And we'll go next to Niamh Alexander with CIBC.

Thanks so much. You talked before about how bifurcation of liquidity pools in any one particular product hasn't historically been successful, but so far we're seeing [INAUDIBLE] benefit substantially from the NYMEX products listing on Globex. Are we at a crossroads here? Could we continue to see a successful bifurcation of liquidity in WTI contract, or are you going to not change on this subject?

I would say we're very much not changed on that topic. You know, again, what we've said is that a long-term bifurcation of liquidity would be quite unusual in these markets. We've had many examples of direct head-to-head competition which normally have not resulted in a long-term sustainable separation of liquidity in a given instrument.

Again, we're very early stages in sort of the development of the energy market electronically. ICE has been I think only competing electronically in the WTI market for, you know, eight months approximately. NYMEX is only, you know, six months, five months into the process, and it's only since September that they've actually listed side-by-side their physically delivered WTI contract electronically.

So this is still very early stages. I would focus you instead on the rapid growth in the WTI market attributable to electronic trading, and also the fact that at this point in time NYMEX has the predominant electronic liquidity in the WTI market.

Thanks. That's helpful. If I could just move on to Swap Stream. It's fully on board now. I'm just wondering, can you maybe update on the initiatives, or the priorities here? Is it kind of grow the Euro-based product? When can we maybe see a U.S.-based product launch and go forward? Thanks.

Swap Stream is primarily a long dated Euro product at this point, but one of the things we have made clear to the market is, you know, we hope to move that into U.S.-based product in 2007. One of the things and one of the reasons for the acquisition is we believe that that market will, over time, become more electronic and having the CME behind it, we think, can open up a lot of new customers to Swap Stream.

Okay. That's helpful. I'll get back in the line. Thank you.

[OPERATOR INSTRUCTIONS] We'll go next to Mark Lane with William Blair and Company.

Good morning.

Hi, Mark.

I wanted to explore, in a little bit more detail, the enhancements to the technology in the interest rate options business, and specifically the user [inscribed] technology. Last quarter there was a discussion about it, you know, it was kind of difficult to quantify maybe what the impact would be. In talking to customers more and doing some more homework can you provide any further detail about what sort of opportunity you see there over the next 12 months?

Mark, it's Rick. User defined spreads, we think, are very important to give customers the type of spreading capability they are used to right now in a pit environment. One of the things, in addition to user defined spreads, is the distribution is still key for our electronic options market to really take off and grow the business. I mean, I think what you've seen over the past couple of years is explosive growth in the Eurodollar options business in general.

I think now we're moving into a phase where the distribution is getting out there. We're working with our channel partners to make sure their front end systems are robust enough to be able to handle the demands of the clients. As that process continues, we believe that over time, electronic trading will continue to grow in the Eurodollar options. If you look at the open interest we have right now, the base of the product has just grown so much. We think we're starting at a much higher level now.

Well, what about the complexity of the new technologies? Are you implying then that that needs a few quarters to develop and get out into the market before you'd see a more meaningful impact?

I think it's very different. Firms are along the curve in very different stages right now, Mark. Some firms will be able to adapt very quickly. Others will have to run it through their systems, through their QA cycles. I think it's on a case-by-case basis at the firm level. The ISVs are at also different levels of development for user defined spreads, as well.

Okay, but even absent that change, this increase in penetration rate of a few percentage points per quarter seems to be something that is sustainable trend in your view?

You know, what we've seen in all of our markets as they go electronic markets, markets tend to grow slowly and as more and more people get connected and the liquidity starts to move there, you start to see some acceleration in volumes on that platform.

Don't forget this is a large opportunity out there. It's 1.2 million contracts of volume, and then we, obviously, collect a higher rate per contract on those as they go electronic.

Okay. Thanks.

We'll go next to Rob Rutschow at Prudential Securities.

Hi, good morning.

Hi, Rob.

Just a couple housekeeping items. I apologize if you already spoke to this, but the professional fees this quarter were down, you know, a couple million. Is that just related to the deal or were there other things at work there?

In the second quarter, they were up a bit because of some of the growth initiatives that we were undertaking where we incurred significant legal fees and other professional fee costs, FX MarketSpace, NYMEX, and Swap Stream are the significant ones there.

Okay. Then in terms of the investment gains it looks like just the back of the envelope calculation. You picked up a couple of basis points of yield there on your cash. Is this more of a run rate going forward?

Yes. I mean most of the cash is invested in money market type instruments so as you see the full effect of the -- all of the Fed increases, we should be approaching our run rate now unless the Fed moves again.

Okay. And just related to the deal. I was wondering if you might be able to give us a little bit more color on how, from a regulatory perspective, how you think the regulators will define sort of the competitive universe and why that will allow you guys to complete the deal?

You know, Rob, I think we don't want to say too much on that. I would just say that, obviously, we've worked very diligently to try to understand and analyze what we think the issues would be from a regulatory perspective. I think that we've had very good advice in that regard and we're confident that we can complete the transaction successfully. I don't want to speculate in a public forum on, you know, sort of the details of that.

Okay. Thanks a lot.

[OPERATOR INSTRUCTIONS] We'll go next to Ken Worthington with JPMorgan.

Hi, good morning. With regard to FX MarketSpace, are you in beta testing at this point, and if not, what milestones need to be reached for you to get there? And are you still on track for a 1Q launch?

Ken, this is Rick Redding. We said that the beta will begin in Q4 and that we will begin trading live in Q1 of '07. We are still confident that we will hit those dates.

Okay, and what milestones still need to be reached for you to get to beta testing?

Clearly, we have some internal work and Reuters has some internal work we need to continue to work on, but most of it that is transparent to the client at this point. There will, obviously, need to be client connectivity to the platform and some clearing work that needs to be done, as well.

Okay. Thank you. And then I wanted to address metal trading again with the CBOT acquisition. I know this question was pursued during the last conference call, but maybe you can help us understand what your options are here. If NYMEX has an exclusive contract to trade on Globex, would you consider shutting down metals, could you sell it? What are the more palatable options under consideration?

I mean, again, we have a lot of issues that we're going to have to work through if we are successful in completing the merger with the Chicago Board of Trade. I don't want to speculate on, you know, how we're going to choose to handle that, but, obviously, we believe that the current agreement that we have with NYMEX is consistent with our acquisition agreement with the Chicago Board of Trade. That will just be one of the many issues that we have to sort through when we get there.

Okay, thank you.

And due to time constraints, we will take our final question from Chris Donat with Sandler O'Neill.

Great. Thanks for taking my follow-up here. Quick question on FX MarketSpace. You've done a pretty remarkable job of getting 16 out of the top 20. How come you didn't get the other four, though? [ Laughter ]

Well, we may have some of the other ones. They just wouldn't allow to us use their names is the story on a couple of them. The other ones, we're continuing to work through the list. The FX MarketSpace team has done an outstanding job getting so many people onto the platform so quickly. You know, their target list is much deeper than the top 20, I can assure you, and they'll continue to work through all of the banks and buy-side clients over the next few months.

Okay. Any chance there'll be another round of early adopters or are the early ones already early?

Well, at some point they don't become early. I think by having these two rounds of early adopters, I think it gives people enough clarity on the breadth of participation that we're likely to see from FX MarketSpace that, you know, I think even more importantly than the sell-side to get some of the buy-side clients that typically are extremely shy to let people know what venues they are trading on. I think that's an impressive list of buy-side participants.

Okay. And we can still expect something on pricing this month? Is that what you discussed at the analyst day?

Yes.

Okay. Thank you.

Thank you.

Thank you.

That does conclude the question-and-answer session. I'd like to turn the conference back over to Craig Donohue for any additional or closing remarks.

Thank you very much for joining us today, and thank you for your continued interest in CME. We look forward to talking with you again next quarter.

That does conclude today's conference, ladies and gentlemen. Again, thank you for your participation. You may now disconnect.