CBOE Trades Private Life for Public
CBOE should generate strong long-term returns, but the IPO doesn't look cheap.
CBOE Holdings will head to market in a few weeks with a proposed offering of roughly $328 million in total. One of the largest trading exchanges in the world, CBOE has scheduled its deal in the midst of an extremely uncertain domestic IPO market. While CBOE has set an offer range of $27-$29 per share, Morningstar analyst Michael Wong estimates that CBOE has a stand-alone fair value of $26 per share, after offering proceeds, special dividend payments, and legal settlements are finalized.
While he has some concerns regarding the competitive and regulatory risks facing the firm, ultimately he believes CBOE should generate strong returns over the long haul, and he offers his investment thesis below:
CBOE's business revolves around providing a marketplace for options trading. Over 70% of the company's gross revenue comes from trade executions on its platform. The remaining revenue is split fairly evenly between fees charged to traders for access to the exchange, service fees charged to support floor traders, data fees primarily based on its share of industry trading volumes, regulatory, and miscellaneous revenues. Following the company's demutualization from a member-owned exchange to a stock corporation, the company plans to generate material incremental revenues from trading permits. There's currently uncertainty in regards to the ultimate demand for the trading permits as charging for access on this scale hasn't been done before. CBOE also owns a futures exchange subsidiary, CBOE Futures Exchange, and a significant interest in an equities trading facility, CBOE Stock Exchange, but they are financially immaterial.
The options exchange trading business has become increasingly competitive. CBOE's dominance in options trading has waned over the years, going from over 50% market share in 1999 to 31% in 2009. A primary reason for the loss of market share has been the proliferation of competitors. In 1999, CBOE competed with three other exchanges while in 2009, it competed with six other exchanges. In 2010, BATS threw its hat into the ring. Besides merely lower pricing, the new entrants brought with them innovative strategies to gain market share such as maker-taker pricing and selling minority equity stakes to broker-dealers.
In spite of competition, part of CBOE's market share is quite sturdy. The company has exclusive index licenses that we estimate are 20%-30% of the company's net transaction fees. That said, the company's highest volume index option, the S&P 500, is only exclusive until 2018. The company also has its second all-electronic options market, C2, initiative that could provide more strategic flexibility. We believe it will remain an uphill battle for the company to even just maintain its current market share, but that any incremental revenues will be highly profitable due to the company's largely fixed cost base.
One scenario that could play out for CBOE is that it is acquired by another exchange group. The financial securities exchange industry has been in a consolidation boom driven by a race to achieve higher economies of scale and diversification of product lines. The more transparent reporting and market established price for CBOE could be what other exchanges have been waiting for. Any takeout price would likely be higher than the company's stand alone value due to cost synergies.
CBOE generated $426 million in operating revenue in 2009, with operating margins of 41.7%. Our $26 fair value estimate is based on a compound annual top-line growth rate of 10% through 2014, with margins reaching into the mid-50s by the fifth year of the forecast, as explained below:
We value CBOE on a stand-alone basis after the receipt of IPO proceeds, paying of a special dividend to former seat holders and settlement class members, and payment of its legal settlement at $26 per share. This equates to a total company value of approximately $2.6 billion based on 102.6 million shares.
We model total gross revenues growing at a compound annual growth rate over the next five years of 10% and medium- to long-term growth of 8%. The growth in the first five years is primarily driven by our forecast of a nearly 12% annual growth in the company's option trading volumes partially offset by 1.5% decline in transaction fees per contract each year.
The 1.5% annual decline is based on our projection of a 3% decline in the company's equity and ETF option pricing and a 1% decline in the company's more exclusive index options. Based on available information, we estimate access fees of close to $100 million by year five, which is an approximately 17% annual rate of growth.
We believe the company's other remaining revenue lines will grow approximately 2.5% per year. Due to the company's operating leverage, we forecast operating margins expanding to the mid 50s by 2014. We utilize a cost of equity of 12% as the company is in a competitive environment, has a large degree of operating leverage, and its product base is not as diversified as other exchanges. We also are assuming a debt to total financial capital ratio of 15%."