In the week since "Exchange Wars" [ICE vs. CME] was published last Sunday, visits to this blog spiked by nearly 500. Given the somewhat esoteric and totally unconventional analysis that appears on my blog, this represented a huge boost in readership. What was responsible? My conclusions were a bit provocative.
First, the analysis of each company plus the object of their affections -- the Chicago Board of Trade (BOT) -- showed that it was in the interest of the Chicago Mercantile Exchange (CME) to pass on this one. I argued they already had 53.8% of the combined revenues of the three companies and acquiring the BOT would give it 84.5% of the market. At that point my analysis said the CME would be over-invested and would, as a result, leave about $100 million in earnings on the table in the first year. This would hurt the merged company's market value.
Second, the analysis documented a good enterprise marketing fit between the IntercontentalExchange (ICE) and the CBOT: the combined companies would maximize earnings at a market share of 52%.
IT TAPPED INTO A CHORD
My post got quite a bit of play the first day from the New York Times DealBook and from SeekingAlpha.com on the second day. Together they generated 109 visitors. One of these visitors probably sparked the critical reply from Jeff Carter, who I don't know, but who seems to have forgotten more about exchange markets than I'll ever know. My reply to his comments and his reply to mine, spell out all the issues I detail. Suffice it to say, that post tapped into a chord.
THREE DROP-DEAD ISSUES
Since my analysis was static (based on a single period), used "interest expense" as a proxy for the cost of goods sold, and was built on financial accounting data, I was not surprised to read that:
1) In a dynamic, growing environment like futures exchange markets, a single period analysis is incomplete, at best;
2) Reported interest expense is not the "cost of goods sold" in futures exchanges; and
3) Financial accounting numbers aren't real economic data and should not be used in M&A analysis. Instead you must use cash flow numbers.
As you can image these comments motivated me to look more closely into the issue and produce an updated analysis that addresses them. That's the purpose of this post.
FUTURES EXCHANGE REVENUE GROWTH
To create a multi-period analysis the Exchange Wars, I had to use nine quarters of data ending in March, 2007 since all three companies have been public only for that time. During that period the same-quarter, year-on growth rate averaged 38%. This supports Mr. Carter's assertion that a single period analysis is incomplete. Applying this growth rate to the historical data produces the following forecast of group revenues through the 2nd 2008. [click to enlarge charts]
ZERO COST OF GOODS SOLD
Whether or not the "cost of money" reflected in a firm's interest expenses is a reasonable proxy for the "cost of goods sold" in financial institutions is, I believe, debatable. What I was trying to capture is average variable cost of a "round turn" trade. But in this case it really doesn't matter because that cost is so small relative to enterprise marketing expenses it can be ignored. In fact, ICE reports its revenues are equal to its gross profits!
THE COMPETITION FOR CAPITAL IS REAL
Financial analyses by the M&A guys in their proxy documents for ICE and CME reportedly use ten year cash flow analysis of each company to support their merger cases. But, these cash flow projections are made for each company separately without incorporating the plans of the competitive bidder in the projections. In short, the case for ICE ignores the impact of CME its projections and visa versa. Though I have not seen these proxy documents, I expect the M&A guys include some vague language about "over reaching" on the one hand and "under estimating" on the other, to address the fundamental issues involving their competition for capital. This just won't do. The competition for capital is just as real as the competition for customers. M&A analysis should build the dynamic effects of competitive plans into all projections.
THE COMPETITION FOR CUSTOMERS IS REAL TOO
For all its virtues in financial analysis, there is one serious failing in cash flow analysis – you can't identify the flow of cash from its source. In other terms, there is no such thing as "activity based cash flow analysis." Despite its limitations, the enterprise marketing expense that firms report in their income statements are as close as a mere mortal can get to building the competition for customers into M&A analyses.
CME's MAXIMUM EARNINGS MARKET SHARE
The results of a maximum earnings market share analysis of the CME over time do not change much from the single period analysis. This chart tells the story.
Actual share (white) has fallen ten share points from 59.3% in March, 2005 to 49.1% in March 2007. At the same time, maximum earnings market share fell from about 60 to 55 share points. Notice how close the CME came to maximum earnings market share in every period until June 2006. Then the gap widened significantly from 100 basis points in March 2006 to 620 basis points in March 2007. What's going on here? Over the nine quarters ICE's revenues increased 280%. This aggressive market expansion has increased the opportunity both for CME and BOT. ... all ships rise with the tide.
CME's MAXIMUM AND ACTUAL EARNINGS
The results are reflected in CME's maximum earnings after enterprise marketing expenses. They achieved almost the greatest relative earnings productivity possible -- the biggest difference between actual and maximum earnings was $8 million in December, 2006.
BOT'S ACTUAL AND MAXIMUM EARNINGS OVER TIME
Group revenues are forecast to increase from $729 to $1,008 million by June 2008. The CBOT's maximum earnings market share increases from 30.73% to 51.23% over the period. This drives its revenues up from $223.94 to $516.30 million.
Since its "cost of goods sold" is barely measurable, these revenues become its gross profits. In order achieve maximum earnings, CBOT's enterprise marketing expenses increase from $86.72 to $251.81 million. This drives EBITDA to increase over two fold, dropping enough earnings to the bottom line to increase EBITDA per share from $1.91 to over $5.01 by the 2nd quarter of 2008. Both EBITDA and enterprise marketing to revenues increase dramatically.
PLAY IT AGAIN SAM
How can the Chicago Board of Trade possibly achieve a market share of 51% in just five quarters? By merging with the IntercontinentalExchange. It this a good idea? Yes, from an enterprise marketing perspective.
THE SCALING FACTOR
But there's another serious concern raised in my discussions with Jeff Carter: can the ICE trading platform be expanded quickly and reliably enough to take on the additional volume of the CBOT? It's no small task. I calculate from CFTC reports that the CBOT had 513 million Open Interest contracts in 2006 on a wide range of commodities. Some of these are not traded on the NYBOT. That exchange had just 160 million Open Interest contracts in 2006. The scaling factor is over 3.5 times. Can ICE deliver on its promise?