CBOE GLOBAL MARKETS INC CBOE
August 22, 2018 - 2:32pm EST by
Supersny
2018 2019
Price: 98.00 EPS 4.75 5.42
Shares Out. (in M): 112 P/E 20.7` 18.1
Market Cap (in $M): 10,960 P/FCF 17.8 16.8
Net Debt (in $M): 1,074 EBIT 771 846
TEV ($): 12,034 TEV/EBIT 15.6 13.8

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Description

 

EXECUTIVE SUMMARY

Do you think investors will care more or less about risk management in the future? Will people continue to look for ways to insure their stock portfolios with the most cost effective way possible? If the answer is yes, then you should buy shares of CBOE as the market is pricing in that they don’t agree. At ~$95, CBOE offers investors an attractive >48% base case upside with an asymmetric upside/downside ratio over the next 12-24 months.

Those who have studied Buffet and Munger understand the true merits of investing in unique “franchise” assets with competitive advantages, barriers to entry and pricing power, which ultimately leads to high returns on invested capital. While everyone realizes the virtues of these qualities, finding a real monopoly-like franchise in the marketplace is a rare find. Furthermore, when these rare gems are discovered investors oftentimes pay too high of a price and realize minimal returns by buying shares in at multiples that are priced for perfection. Nevertheless, investors can now purchase shares of CBOE, which fits this rare mold while trading at a five year low sentiment and valuation.

In an investment industry where there is more and more bifurcation across investment time horizons and more investors only focused on a quarterly time frame, CBOE is a perfect way to let the market serve you outsized risk adjusted returns by skating to where the puck is going to be and by buying shares before VIX trading volumes rebound, CBOE realizes the full extent of its BATS synergies and sell-side consensus revises its estimates back upwards.

CBOE is one of the highest quality businesses in the world with >60% EBITDA margins (going to ~70%) and monopoly-like end markets. Yet the stock is down ~30% from its highs realized before the VIX spiked in early Feb 2018. Many believe that the secular growth in VIX is over and structurally lower volumes are here to stay. However, VIX volumes been weak after previous VIX spikes (Aug 2015) before growth continued several months later and my research concludes that there are structural reasons as to why this will once again be the case.

CBOE shares provide an attractive entry point with shares trading at ~20x 2019 consensus, or a ~20% discount to its five year average. Moreover the key investment factors of this thesis hinge upon: 1) CBOE is a high quality business with tremendous secular tailwinds – time is your friend 2) lower VIX trading volumes is transient, 3) CBOE’s BATS deal is transformative and synergies will be higher than consensus expects and 4) there are many free upside options as well as many ways to win.

Putting this all together one has the ability to generate significant alpha due to this variant perception while taking minimal business quality and execution risks. At the end of the day, CBOE has a strangle hold on the trading of VIX and SPX derivatives and the business remains in its early innings of secular growth in a Visa-like quality business with strong imbedded network effects.

As investors wait for VIX volumes to rebound, I believe CBOE’s valuation has limited risk of falling much below 20x as it would just lead to an opportunistic buyout by one of the many larger exchanges. Due to significant synergies available when exchanges merge there has been over ten years of consistent M&A and just a handful of global exchanges remain. Given CBOE’s <$11bn market cap, it remains that last needle moving acquisition candidate in the global exchange space as consolidation nears its end.

COMPANY BACKGROUD

CBOE was founded in 1973 as a non-stock corporation owned by its members and was the first organized marketplace for the trading of exchange-traded options on equities. In June 2010, CBOE demutualized and its members floated shares through an IPO. On March 1, 2017, acquired BATS for ~$3.5bn. The deal was funded by ~20mn CBOE shares and the balance in cash. BATS deal significantly expanded CBOE’s product lines across multiple asset classes adding European equities and forex, broadened its geographic reach with pan-European exposure and diversified its business mix with significant non-transactional revenue streams. In addition, CBOE plans to leverage BATS’ market leading proprietary trading technology by migrating the trading of CBOE securities onto BATS’ superior single technology platform. Following the acquisition of BATS, its name was changed to CBOE Global Markets, Inc.  

CBOE operates the oldest options exchange in the US, where customers buy or sell index options & futures, multi-list ETFs and equity options both electronically and through open outcry on its trading floor in Chicago. Through BATS, CBOE operates an electronic exchange for listed cash equities, ETFs, ETF / equity options, and forex. CBOE now has the second largest share of US equity trading with ~20% market share. In Europe, CBOE operates the largest pan-European equity exchange with a ~21% market share. Lastly, CBOE has a ~15% market share in listed global forex trading

However, what is most intriguing is that CBOE is essentially a legal toll road monopoly in the trading of SPX and VIX derivatives. CBOE pioneered the volatility trading space with its introduction of futures on the VIX Index in 2004 and options on the VIX Index in 2006. Since its creation the VIX Index has become the world’s barometer for equity market (S&P 500) volatility as it is designed to reflect investors’ consensus view of future 30-day expected stock market volatility. Since CBOE created VIX and this asset class, trading in VIX futures and options products have exploded in terms of popularity and usage. In addition, CBOE also offers exclusive options on the S&P 500 Index, the largest and most liquid equity exchange in the world.

In 2017, ~64% of revenues came from transaction fees, while 36% came from recurring data and service related fees. Of these transaction fees ~68% of them took place in futures and index options where CBOE has a monopoly and these products can’t be traded anywhere else. In all, ~80% of CBOE revenues come from proprietary products with monopolies or high quality recurring data revenues.

Target Price & ValuatioN

·         CBOE’s historical five year average multiple is ~23.5x forward P/E

·         CBOE has historically traded at a premium to the peer group, which is justified given:

o    Small scale, leading to faster organic growth

o    Monopoly positions / pricing power in the trading of SPX / VIX products

o    Potential takeout candidate in the context of an industry that it is becoming increasingly consolidated (potentially by CME, ICE, LSE or Deutsche Bourse)

·         CBOE had traded at >25x forward P/E in the past year as CBOE trading volumes were strong and the market became enthusiast about BATS acquisition and the potential synergies. It has since pulled back to ~20x forward P/E.

·         Based on my model, I believe that CBOE is worth ~$139 (~46% upside) with ~2.0% from 1.5 years of dividends or ~48% of total upside based on my 2020 figures.

·         For my base case I use ~22x forward P/E, vs. a current ~20x forward P/E and I believe CBOE’s multiple may expand back towards ~24-25x P/E once VIX volumes show a sustained inflection point and BATS synergies are revised higher

OVERVIEW OF VARIANT PERCEPTION

VIX Franchise Growth Prospects

Street view: Most of the market believes that the slowdown in VIX futures and options is structural and longer term in nature. Also there is misplaced fear of potential regulatory actions (fines, mandated changes to VIX) against CBOE. Uncertainty has led to reduced VIX growth assumptions and recent short VIX ETF AUM losses are viewed by the market as structural. Sell side is modelling a ~3% organic revenue in 2019 and ~5% in 2020, despite that fact that CBOE PF organic growth has been ~8% over the past five years.

My View: Based on my extensive company and industry research as well as VAR calls, I believe that the long-term growth prospects of the VIX franchise have not been impaired. Feb 2018 will end up being just like the Summer 2015 spike in VIX which lead to a few Q’s of volume weakness before returning to its strong historical growth rates. In addition, I have been able to refute any potential regulatory or legal concerns. In addition, I believe that the market is overly focused on short VIX ETF AUM which directly only accounts for ~5% of VIX volumes.

I don’t believe that recent events will lead to structural lower trading volumes and I expect 6% organic revenue growth in 2019 and >8% in 2020. In addition, I believe we are getting a free option on potential acceleration of growth driven by increased market volatility and / or increased electronic trading of CBOE’s products on BATS’ exchanges as they finish integration in 2019.

Cost Synergies

Street view: Consensus is modeling cost synergies in line with management’s guidance ($85mn over 4 years). Yet, CBOE’s stock has only outperformed the S&P 500 by 10% since the deal was announced, despite the fact that BATS was highly accretive and CBOE’s EPS is expected to double from 2016 to 2019.

My View: My base case assumes that management achieves >$110mn of cost synergies by 2020, driven by eliminating CBOE’s technology systems, optimizing corporate / support functions, reducing professional service fees and consolidating real estate. Moreover, much of this synergies uplift remains for 2019

Other Free Options

Street View: The street does not assume any additional value creating capital allocation and they don’t assume any volume uplift from new product launches and/or electrification of CBOE products

My  View: I believe that buybacks and M&A will drive additional shareholder value (either through inorganic growth as an acquirer or as a take-out candidate). CBOE has already announced an incremental $250mm in buyback repurchase authorizations since February 2018, roughly a year earlier than consensus expectations. Moreover, CBOE stands to benefit from significant volume due to new product launches and the electrification of CBOE pit focused products.

Overview of Implied Expectations

Given CBOE’s non-transactions revenues will grow ~5-6%; I believe consensus is modeling flattish transaction revenues for 2019. In addition, based on consensus EBITDA estimates it implies that CBOE OpEx will grow ~7% in 2020 vs. its historical avg of low-single digits OpEx growth.

Overview of KEY INVESTMENT FACTORS (KIFS)

·         KIF #1: High Quality Business with Secular Tailwinds

·         KIF #2: Lower VIX Volumes & Trading is Transient

·         KIF #3: BATS Deal is Transformative & Highly Accretive with Low Consensus Synergies Estimates

·         KIF #4: Free Upside Options & Many Ways to Win

KIF #1 High Quality Business with Secular Tailwinds

CBOE is a unique asset in terms of its barriers to entry, competitive advantages, business quality as well as its secular growth and tailwinds. In my differentiated view, CBOE represents an extremely cheap MasterCard or Visa-like network business in it early innings, where there is significant volume upside ahead with limited incremental costs associated with this uplift in revenues.

CBOE is unlike most of exchanges as it holds the exclusive license (read monopoly) to list index options on the S&P 500 Index (SPX) as well as its own proprietary VIX Index suite of products, which together represent ~2/3 of CBOE’s transaction revenues 

As a function of these exclusive relationships and intellectual property, the company has demonstrated considerable pricing power in its proprietary products, typically raising price 2-3% per year on average over the last few years whereas most other exchange products are seeing structural price pressure as investors can buy and sell various multi-list products such as equities and equity options on multiple exchanges. This is simply not the case for CBOE’s VIX & SPX franchises and this has allowed for continued CBOE futures price increases from already high levels while pricing on nearly every other exchange traded product has seen massive and/or continued price deflation.

Since CBOE created the VIX as well as options and futures on this “fear gauge” in 2004 the VIX has grown from a small niche product to an asset class in itself. Long term secular adoption and usage of VIX continues to expand as more and more market participants and institutions seek unique ways to cheaply mitigate downside exposure to equity markets. Outside of S&P 500 puts, which are tied to a specific market level, VIX offers structural advantages in that it is based on an absolute level. In addition, movements in the VIX are usually multiples (5-10x) of the underlying declines in the S&P 500. It will take time for many to realize that VIX represents one of the best bangs for your buck in terms of hedging equity exposure and institutional adoption should continue to increase for many years to come. Strong growth behind VIX futures has already led for VIX futures revenue to increase from ~3% pre-BATS trading revenues to ~20% of 2017. 

Also, while there are substitute products for hedging equity exposure, SPX options have significant economic benefits for institutional investors hedging in size. In fact, the closest alternative to SPX options costs 7x the price to trade the same notional 

On top of this, how many businesses do you know with >60% EBITDA margins that are rising to ~70% over the next ~3 years where D&A is a low portion of the EBITDA? CBOE’s business model is highly scalable with large fixed costs and super high incremental margins (~75%) as there are low variable costs for incremental trading volumes. As such, accelerating volumes drives outsized profit growth as volumes ramp up. Furthermore, in CBOE’s Futures business, where the short term pain of weaker VIX volumes is being felt, there are even better margins as it earns >90% EBITDA margins.

Along with monopoly like pricing power and high margins, CBOE still has tremendous growth ahead of it. CBOE futures volms have grown from ~4mn ADV to ~300mn in ADV over the last 10 years and from ~159mn to ~293mn (~2x) over the last five years. Despite this tremendous growth, CBOE is still relatively early in growing its user base, which it has accomplished through an extension of trading hours and through broad-based education of traders. In the past, CBOE reported revenue growth has been dragged down by CBOE’s non-proprietary equities business which continues to flat line and become a much lower % of CBOE’s product mix. Going forward this should be a much smaller headwind (due to its size) or even a tailwind due to greater price rationality now that CBOE owns BATS, the industry price disruptor.  In all, these proprietary products now represent ~90% of CBOE’s transaction revenues (pre-BATS deal) up from ~50% in 2010.

As a result of this monopoly in VIX, CBOE is also uniquely positioned to monetize the proprietary data that is associated with VIX & SPX trading. However, CBOE is also in the early innings of monetizing its data as more and more investors leverage this data as a mission critical element to their trading strategies. This should allow CBOE’s non-trading revenues (~36% of sales) to continue compounding at MSD rates for the next 5-10 years and grow faster than data revenue at other exchanges which continue to grow at a LSD-MSD clip.

Nevertheless, CBOE isn’t resting on its laurels and there are strong secular tailwinds behind some of their newer products as well. They are rolling out new products such as ETFs, bitcoin futures as well as the first ever options and futures on fixed income indices coming in August 2018 which will contribute to accelerating growth over time.

On top its high margins, strong growth and low CapEx (~3% of sales), CBOE has also been a large beneficiary from US tax reform as they generate ~90% of revenues in the US and its tax rate dropped from 39% to ~27%. This is a recipe for strong revenue to FCF conversion and I believe that >45% of each dollar in revenue will be converted to FCF in 2018-2020.

KIF #2: Lower VIX Volumes & Trading is Transient

Despite CBOE’s business quality and long term secular growth, CBOE and VIX volumes have recently been under pressure as a result of the Feb 2018 VIX flare up. Many believe that the long term growth story in CBOE is permanently impaired. Based on my work, I believe this is simply not the case and this is just a speed bump in the road towards longer term growth.

Due to the way risk/insurance is priced, the futures curve for VIX is normally in contango, meaning the future contracts trade at a premium to the spot VIX. (see below)

When volatility or fear remains muted this future contract eventually converges with the lower spot market level allowing speculators an attractive means of profiting by shorting VIX futures. The last several years witnessed muted volatility, with near all-time lows in 2017 due to strong corporate profit growth, accommodative monetary and fiscal policy as well as limited systematic risk events like terrorist attacks. This allowed speculators to realize handsome profits as they continued to short VIX futures in increasing size. Moreover, many less experienced investors piled into this trade via the proliferation of short and levered short VIX ETFs which attracted an increasingly naïve retail base of retail investors.

This trade became more and more crowded until the Feb. 5th VIX shock, when a small increase VIX levels led to a liquidity squeeze which rippled across the equity volatility landscape. When it was all said and done the VIX closed up over 100% on the day. While the risk off on Feb 5th was exacerbated by technical factors, the impact has continued to make its presence felt in the VIX market. This shock led to a flattening of VIX future curve as the near term/spot rose while longer dated VIX futures barely moved and this flattening of the curve remained in place for several weeks. Generally speaking, a flatter VIX curve is a headwind to volumes as there are less ways to play the VIX curve and as seen by weaker recent trading volume data.

AUM in VIX ETF complex has also declined post the Feb 2018 spike. From >$400mn at the end of 2017 across all short VIX futures ETFs, AUM has dropped to ~$200mn. Events of Feb 5th led to the forced closure of the XIV ETF and substantial losses for the SVXY ETF. As a result of this pain, many levered ETFs have revised leverage targets lower, which has also led to less VIX buying and selling by ETFs. However, I believe this volume should return over time as contango has returned to the VIX curve. Despite this drop in short VIX ETF AUM, AUM in long VIX ETFs have held their approximate levels.

Nevertheless, adoption of VIX has not and will not be a straight line. There have been numerous VIX spikes which have led to the harvesting of VIX “insurance policies” as well as a subsequent short-term flattening of the VIX futures curve. As was the case in August 2015, it is common for large short-term spikes in VIX to lead to a short-term reduction in VIX trading volumes and open interest. Post the August 2015 spike the VIX call option open interest declined by ~50%, but it gradually recovered as volatility normalized. In the case of 2015 it only took a few quarters until VIX volumes began rebounding and continuing towards their long-term secular growth. I believe it is only a matter of time before this will happen again given the secular tailwinds associated with the VIX asset class. Even during the financial crisis volumes in the VIX suite proved their resiliency and grew despite the macro headwinds.

The rebalancing of these short VIX ETF flows, which has been a source of volume headwinds, is near complete and levered VIX ETFs have normalized at ~5% of daily volumes vs a previously estimated ~10% of volumes. Despite this VIX headwind, however, SPX volumes have picked up as traders have shifted from using VIX to SPX options to hedge market price movements.

Moreover, the speed and magnitude of the pain on the short VIX community was unprecedented and led many to cite conspiracy theories around whether the VIX was broken, manipulated or even flat out fraudulent. After speaking with former regulators, exchange executives and industry experts, I believe this VIX spike confirmed two things: 1) VIX as an asset class is in its infancy and demand can easily overwhelm supply (or vice versa) due to an immature market structure and 2) there is a long way to go in terms of investor education around what VIX is and how it works.

CBOE is addressing these concerns as they have brought more market makers into the VIX settlement, which will make for deeper liquidity, more efficient pricing and higher volumes in the future. Also, while there were many short VIX investors that lost a lot of money, I can confirm that there was nothing nefarious, illegal or broken about the VIX and how the asset class is priced and I believe this risk will be extinguished as time passes.

As was the case with credit cards, they were once seen as very dangerous and fraught with risks before education was established and they soon became useful financial tools for the masses. I believe that hedging and the use of VIX as an asset class could similarly be just in its infancy as an asset class and time and education will similarly lead to long term growth and adoption of this new financial product over time.

In addition, there are many downside mitigants in the near term as we wait for VIX volumes to rebound. VIX and SPX are complementary assets and a flat VIX curve has led many traders to increase their volumes in SPX options instead as evidenced by strong index options volumes in Q2. In addition, market participants have already seen the benefit of early CBOE product transition on to the BATS exchange and management expects August 1st pricing changes will provide modest growth off the Q2 base.

Lastly, while many see lower VIX ETF volumes as a structural risk for lower VIX demand, I believe this is circular and more of a lagging proxy for VIX demand rather than the cause for lower VIX trading volumes. Open interest in the VIX has already bottomed and continues to build as the VIX curve has normalized (returned to contango) and many investors return to seeking VIX exposure.

Encouragingly, VIX futures open interest has increased by 23% since the end of July and now sits at its highest level since February. In addition, month-to-date average daily volume (ADV) is up 27% from July levels and on pace to be the contract’s best volume month since March. Also, August month to-date ADV for VIX options is up 30% from a very soft July and open interest appears to have stabilized. While both volumes and open interest remain well below pre-February levels, the stability and growth in these contracts are signs that we have potentially reached a positive inflection point in terms of VIX trading volumes

KIF #3: BATS Deal Transformative & Highly Accretive

In September 2016, CBOE announced that it would acquire BATS for $3.5bn, equivalent to 13x 2016 EV/EBITDA, or 10.5x including original targeted synergies of $65mn over ~5 years (by 2021). The deal closed in March 2017 and was financed low-cost debt (~3% cost) and ~20mn CBOE shares which allowed the BATS management team to participate in upside

In acquiring BATS, CBOE acquired the best and structurally advantaged (cheapest and fastest) exchange platform. One of the main motivations was for CBOE to put its best in class products on BATS’ best in class exchange technology. Before this acquisition, CBOE had a remarkably high ~50% of its trading volumes coming from antiquated open pit trading vs. BATS ~100% electronic volumes. BATS was originally founded in 2005 as a consortium effort financed by broker-dealers and trading firms to provide a low-cost alternative to the dominant U.S. equity exchanges (NYSE and NASDAQ). BATS built its electronic-only exchange on scalable Linux-based technology and this, coupled with its geographically-advantaged footprint in Kansas City, allowed BATS to price transaction fees at a massive discount to incumbents which led to significant share gains in cash equities and multi-list equity options. For example, standalone BATS was able to price trades for U.S. equities and multi-list options at a ~50% discount to Nasdaq / NYSE and this disruptive pricing drove BATS equities market share from ~0% in 2006 to ~20% today.

Furthermore, BATS’ trading platform experiences very low operational downtime and low latency vs. CBOE’s platform and other electronic exchanges. This reliability, capacity and speed allows for faster trades, which can lead to increased volumes by traders who were previously deterred from trading on CBOE’s old inferior electronic platform which frequently had latency issues.

Interestingly, the BATS acquisition should be viewed more like a reverse-merger in that the BATS’ team will be running the integration process / synergy effort. The BATS management team (Chris Concannon and Chris Isaacson) has significant M&A experience as they have completed three acquisitions in the last seven years and they have a strong track record of materially beating synergies guidance.

In general, exchange acquisitions are highly accretive to cash earnings given more volume spread over a fixed cost base and I believe management’s original cost synergy guidance of $65mn over 5 years understates the magnitude of synergies and overstates the timeline. The original target of $65mn only implied 34% of BATS’ OpEx base vs. ~70% OpEx savings achieved by the BATS team in historical deals. Furthermore, I believe the correct way to look at it is really as a function of both BATS’ and CBOE’s OpEx cost base combined. CBOE guided that ~70% of synergies will be derived from eliminating CBOE’s technology systems and the rest will come from optimization of corporate / support functions, reducing professional service fees and consolidating real estate in New York and London.

In its first year (2017), management already ran well ahead of its initial synergy targets ($33mm run-rate vs. $15mm target). Management has now guided towards $85mn over 4 years (by 2020) but I think it will be >$110mn over ~3 years. Based on my analysis, CBOE should be able to easily eliminate >$30mn of professional fees and >$20mn in duplicative systems expenses once CBOE’s exchanges are migrated to BATS’ technology. For more color on BATS synergies please refer to the Appendix. Ultimately, the BATS transaction will be ~80% accretive vs. standalone 2019 CBOE EPS as the company outperforms its cost synergy targets.

Moreover, most of the cost synergies are yet to come as the largest CBOE products won’t be moved on to BAT’s exchange until October 2019 when all systems will be fully integrated. This is expected to yield significant cost synergies and potential revenue synergies from a more efficient platform with better complex order handing. BATS has the lowest cost structure (OpEx and CapEx) in the industry and much of CBOE’s legacy support costs will be eliminated once the migrations are complete. This will lead to significant margin expansion and a synergies surge in 2019. Lastly, CBOE hasn’t provided any revenue synergies targets, but they could be significant as electrification of other exchange products historically has led to large increases in trading volumes.

KIF #4: Additional Upside Options for FreE

Revenue Synergies

On top of cheap valuation for a very high quality business, CBOE stands to benefit from significant potential revenue / volume benefits due to 1) further electrification of CBOE index options once they are migrated to BATS’ technology platform 2) cyclical upside in volatility as the Fed and others continue raising interest rates 3) the potential to leverage BATS’ European sales force to cross-sell CBOE’s proprietary products 4) a more rationale pricing environment as CBOE has eliminated the main disruptor in the multi-list equity options market and 5) new product introductions including bitcoin futures, ETF listings and fixed income index futures and options.

Prior to the BATS transaction CBOE was unique in that it had a weak electronic trading platform and ~50% of volumes remained fit traded. As CBOE moves its products onto BATS’ platform CBOE products should see a volume uplift as similar products have benefitted from a ~25-50% uplift once products move from open outcry to electronic ordering. Due to the early success in transitioning CBOE products on to the BATS’ backbone, CBOE has commented that this has already led to larger sized bid-ask orders as traders benefit from better trading systems, improved order book depth and lower latencies. While I don’t give them any credit for volume/revenue synergies, this is also not baked into any of the consensus estimates

Industry Consolidation Winner

Given its <$11bn market cap, CBOE remains the last needle moving acquisition candidate in the global exchange space as consolidation nears its end. Due to large synergies available when exchanges merge there has been over ten years of consistent M&A and just a handful of global exchanges remain with strong product and geographical diversity.

Anti-trust / competition concerns are already front and center and has already led to the rejection of LSE’s acquisition of Deutsche Bourse in 2017. Given that CBOE’s proprietary VIX & SPX franchisees has limited product overlap with other exchanges there is limited competition risk outside of US equities. Moreover, as CBOE doesn’t own strategic geographical equity exchanges there is little risk that politicians would move to block the acquisition of CBOE as politicians have done in the case of the ASX/Singapore and others have threatened to do so in the case of a few other local equity exchanges

In the past CBOE shares have garnered an appropriate take out premium in its multiple due to its scarcity value and its ability to court multiple suiters, but this no longer exists as CBOE hovers at ~20x forward P/E or its lowest valuation in five years. It has long been rumored that CME might acquire CBOE and consolidate the two complimentary Chicago exchange powerhouses. In regards to product overlap this is limited in the case of CBOE/CME. While CME has particular strength in commodities and fixed income, CBOE boasts the unique VIX and SPX franchises, equities, multi-list equity options and forex. On top of this LSE, remains well capitalized and highly interested in yet another needle moving deal as its DB takeover was blocked. Finally, ICE, which has a long history of aggressive M&A under CEO Jeff Sprecher, is not a buyer that should be ignored as they have historically been a serial acquirer. Furthermore, it has been several years since ICE’s last large acquisition. However this deal would probably require ICE to divest CBOE’s equities business as ICE already controls the #1 US equity exchange in NYSE. This seems easily do-able and would likely solicit interest from multiple strategic suitors

As investors wait for VIX volumes to rebound, I believe CBOE’s valuation has limited risk of falling much below 20x as it would just lead to an opportunistic buyout by one of the many exchanges seeking the one last needle moving acquisition that is available in the consolidated global exchange industry.

Increasing Capital Allocation

In addition, CBOE investors get additional upside from capital allocation as free upside. Prior to the BATS deal, CBOE had retired ~15% of its shares from 2010-2016, or ~3% of shares per annum. Upon announcing the BATS deal, CBOE put buybacks on hold as its ND/EBITDA leverage ratio briefly hit >2.2x. Management guided towards not returning to capital allocation until they had paid down the BATS bonds which implied that capital allocation would be on hold until 2019. However, CBOE has been a large beneficiary of corporate tax reform and this allowed for more accelerated debt pay down.

CBOE has already delevered to a conservative <1.5x ND/EBITDA and on the backs of this transient share price weakness CBOE has already initiated $250mn of buybacks since Feb 2018, or nearly one year ahead of expectations. The earlier-than-anticipated buyback program announced in February 2018 signals optimism and comfort around running a levered balance sheet (previously net cash).

The company has historically allocated ~80% of its FCF to buying back stock and paying dividends but if management were to maintain ~2x Net Debt/EBITDA leverage profile this would provide ~10% of additional upside

Moreover, CBOE sits at a sweet spot within the exchange industry as it is small enough to be a takeout candidate for many larger suitors, but it’s also large enough to roll up various regional exchanges using the BATS’ platform. BATS’ team brings a new expertise in capital allocation and M&A integration. BATS has grown its business through a series of highly successful acquisitions, expanding into other geographies and asset classes. Now that BATS’ technology will be run on CBOE’s exchanges, there are still several regional stock exchanges that could be targets / tuck-ins. VAR suggests that former BATS CIO (current CBOE CIO) has developed an easily replicable blueprint for migrating exchange technologies to the BATS platform. In each instance, once technology integration occurred, BATS was able to substantially reduce headcount and technology-related expenses allowing for highly accretive M&A

Product Launch Upside

CBOE also has a long history of product innovation including the advent of VIX and its product suite. CBOE has continued to be aggressive in new product launches and were one of the first to launch bitcoin futures in late 2017. In addition, CBOE expects to launch iBoxx corporate bond futures later in August 2018 (Q3) with first a HY index and then an IG index. This is the first exchange traded futures product linked to broad corporate bond indices and with Blackrock’s buy-in this should create long term volume tailwinds especially as new fixed income options and futures products ramp over the next ~12 months. The Corporate Bond Index Futures contracts with options & futures also has strong support from largest FI investors / ETF providers (Blackstone, State St, etc.

All of the above catalysts provide free upside to CBOE’s share price and provide investors many additional ways to win that is not included in consensus estimates.

MANAGEMENT OVERVIEW

Edward T. Tilly.  Mr. Tilly is our Chairman and Chief Executive Officer. Mr. Tilly has served as our Chairman since February 2017 and as CEO and director since May 2013.  Prior to becoming CEO, Mr. Tilly served as President and Chief Operating Officer from November 2011, and Executive Vice Chairman from August 2006 until November 2011. He was a member of CBOE from 1989 until 2006, and served as Member Vice Chairman from 2004 through July 2006. Mr. Tilly serves on the board of directors of the OCC. He holds a B.A. degree in Economics from Northwestern University.   

Christopher R. Concannon.  Mr. Concannon is our President and Chief Operating Officer, a position he was appointed to upon the Company’s acquisition of BATS.  Previously, he served as BATS’ President since December 2014, director since February 2015 and CEO since March 2015. Prior to joining BATS, Mr. Concannon was most recently a president and chief operating officer at Virtu Financial, a global electronic market maker, from 2009 to 2014.  Mr. Concannon holds a B.A. degree from Catholic University, an M.B.A. degree from St. John's University and a J.D. degree from Catholic University's Columbus School of Law.

Brian N. Schell.  Mr. Schell currently serves as our Executive Vice President, Chief Financial Officer and Treasurer, a position he has held since January 1, 2018. Previously, he was Deputy Chief Financial Officer of the Company’s subsidiary CBOE Exchange, Inc., a position he was appointed to upon the Company’s acquisition of BATS.  Prior to that, he served as Chief Financial Officer of BATS since March 2011. Prior to joining BATS, he held various senior leadership positions at H&R Block Inc., as well as various positions at the FDIC, KPMG and JP Morgan. Mr. Schell holds a B.B.A. degree with an emphasis in finance from the University of Notre Dame and an M.B.A. degree from The George Washington University.     

Christopher A. Isaacson. Mr. Isaacson is our Executive Vice President and Chief Information Officer, a position he was appointed to upon the Company’s acquisition of BATS.  Previously, he served as BATS' Executive Vice President and Global Chief Information Officer since February 2014 and he has held other various senior leadership positions since 2005.  Prior to being one of the founders of BATS, Mr. Isaacson was a software developer at Tradebot Systems, Inc. from 2003 to 2005. Mr. Isaacson holds a B.S. degree in information systems with a minor in math from Nebraska Wesleyan University and an M.B.A. degree from the University of Nebraska-Lincoln.    

CAPITAL ALLOCATION OVERVIEW

Until CBOE acquired BATS for $3.5bn in March 2017 the company had run with net cash and frequently bought back shares at a rate of 2-3% of shares outstanding per annum. On top of this CBOE pays a nice dividend of $1.24/share per share (~1.3% yield), which has continued to increase by 10-15% per annum. Going forward dividends are expected to grow in-line with EPS and continue to increase by 10-15% y/y per annum.

However, as stated above, in February, post VIX flare up, CBOE re-instated its buyback (~1 yr early) with a $150mn authorization before adding another $100mn authorization in August 2018. Company is only levered ~1.4x ND/EBITDA and despite modeling increasing buybacks, assuming buybacks of $290mn in 2018 and $500mn in both 2019 and 2020, CBOE will only be levered ~1.1x 2020 YE

CBOE Top Holders

·         Hedge Funds own ~12% of shares

·         BoD holds ~1% of shares

·         Long time CEO Ed Tilly only owns ~100,000 shares

·         While potential successor, Concannon Chris owns >150,000 shares and recently bought ~10,000 shares in the open market on May 30th.

SENTMENT

·         Sentiment is still mixed with many skeptical holds and few buy ratings

·         Sell side #s have come down over the last six months as they are modeling long term growth headwinds in CBOE’s VIX product suite

Estimates vs. Share Price Analysis (EEG)

·         CBOE share price is -25% whereas 2019 EPS estimates have declined by ~7%

·         Much of this share price weakness has been relegated to multiple contraction as the buyside has lowered its numbers below consensus levels.

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Rebound in VIX volume. Higher than expected BATS synergies

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    Description

     

    EXECUTIVE SUMMARY

    Do you think investors will care more or less about risk management in the future? Will people continue to look for ways to insure their stock portfolios with the most cost effective way possible? If the answer is yes, then you should buy shares of CBOE as the market is pricing in that they don’t agree. At ~$95, CBOE offers investors an attractive >48% base case upside with an asymmetric upside/downside ratio over the next 12-24 months.

    Those who have studied Buffet and Munger understand the true merits of investing in unique “franchise” assets with competitive advantages, barriers to entry and pricing power, which ultimately leads to high returns on invested capital. While everyone realizes the virtues of these qualities, finding a real monopoly-like franchise in the marketplace is a rare find. Furthermore, when these rare gems are discovered investors oftentimes pay too high of a price and realize minimal returns by buying shares in at multiples that are priced for perfection. Nevertheless, investors can now purchase shares of CBOE, which fits this rare mold while trading at a five year low sentiment and valuation.

    In an investment industry where there is more and more bifurcation across investment time horizons and more investors only focused on a quarterly time frame, CBOE is a perfect way to let the market serve you outsized risk adjusted returns by skating to where the puck is going to be and by buying shares before VIX trading volumes rebound, CBOE realizes the full extent of its BATS synergies and sell-side consensus revises its estimates back upwards.

    CBOE is one of the highest quality businesses in the world with >60% EBITDA margins (going to ~70%) and monopoly-like end markets. Yet the stock is down ~30% from its highs realized before the VIX spiked in early Feb 2018. Many believe that the secular growth in VIX is over and structurally lower volumes are here to stay. However, VIX volumes been weak after previous VIX spikes (Aug 2015) before growth continued several months later and my research concludes that there are structural reasons as to why this will once again be the case.

    CBOE shares provide an attractive entry point with shares trading at ~20x 2019 consensus, or a ~20% discount to its five year average. Moreover the key investment factors of this thesis hinge upon: 1) CBOE is a high quality business with tremendous secular tailwinds – time is your friend 2) lower VIX trading volumes is transient, 3) CBOE’s BATS deal is transformative and synergies will be higher than consensus expects and 4) there are many free upside options as well as many ways to win.

    Putting this all together one has the ability to generate significant alpha due to this variant perception while taking minimal business quality and execution risks. At the end of the day, CBOE has a strangle hold on the trading of VIX and SPX derivatives and the business remains in its early innings of secular growth in a Visa-like quality business with strong imbedded network effects.

    As investors wait for VIX volumes to rebound, I believe CBOE’s valuation has limited risk of falling much below 20x as it would just lead to an opportunistic buyout by one of the many larger exchanges. Due to significant synergies available when exchanges merge there has been over ten years of consistent M&A and just a handful of global exchanges remain. Given CBOE’s <$11bn market cap, it remains that last needle moving acquisition candidate in the global exchange space as consolidation nears its end.

    COMPANY BACKGROUD

    CBOE was founded in 1973 as a non-stock corporation owned by its members and was the first organized marketplace for the trading of exchange-traded options on equities. In June 2010, CBOE demutualized and its members floated shares through an IPO. On March 1, 2017, acquired BATS for ~$3.5bn. The deal was funded by ~20mn CBOE shares and the balance in cash. BATS deal significantly expanded CBOE’s product lines across multiple asset classes adding European equities and forex, broadened its geographic reach with pan-European exposure and diversified its business mix with significant non-transactional revenue streams. In addition, CBOE plans to leverage BATS’ market leading proprietary trading technology by migrating the trading of CBOE securities onto BATS’ superior single technology platform. Following the acquisition of BATS, its name was changed to CBOE Global Markets, Inc.  

    CBOE operates the oldest options exchange in the US, where customers buy or sell index options & futures, multi-list ETFs and equity options both electronically and through open outcry on its trading floor in Chicago. Through BATS, CBOE operates an electronic exchange for listed cash equities, ETFs, ETF / equity options, and forex. CBOE now has the second largest share of US equity trading with ~20% market share. In Europe, CBOE operates the largest pan-European equity exchange with a ~21% market share. Lastly, CBOE has a ~15% market share in listed global forex trading

    However, what is most intriguing is that CBOE is essentially a legal toll road monopoly in the trading of SPX and VIX derivatives. CBOE pioneered the volatility trading space with its introduction of futures on the VIX Index in 2004 and options on the VIX Index in 2006. Since its creation the VIX Index has become the world’s barometer for equity market (S&P 500) volatility as it is designed to reflect investors’ consensus view of future 30-day expected stock market volatility. Since CBOE created VIX and this asset class, trading in VIX futures and options products have exploded in terms of popularity and usage. In addition, CBOE also offers exclusive options on the S&P 500 Index, the largest and most liquid equity exchange in the world.

    In 2017, ~64% of revenues came from transaction fees, while 36% came from recurring data and service related fees. Of these transaction fees ~68% of them took place in futures and index options where CBOE has a monopoly and these products can’t be traded anywhere else. In all, ~80% of CBOE revenues come from proprietary products with monopolies or high quality recurring data revenues.

    Target Price & ValuatioN

    ·         CBOE’s historical five year average multiple is ~23.5x forward P/E

    ·         CBOE has historically traded at a premium to the peer group, which is justified given:

    o    Small scale, leading to faster organic growth

    o    Monopoly positions / pricing power in the trading of SPX / VIX products

    o    Potential takeout candidate in the context of an industry that it is becoming increasingly consolidated (potentially by CME, ICE, LSE or Deutsche Bourse)

    ·         CBOE had traded at >25x forward P/E in the past year as CBOE trading volumes were strong and the market became enthusiast about BATS acquisition and the potential synergies. It has since pulled back to ~20x forward P/E.

    ·         Based on my model, I believe that CBOE is worth ~$139 (~46% upside) with ~2.0% from 1.5 years of dividends or ~48% of total upside based on my 2020 figures.

    ·         For my base case I use ~22x forward P/E, vs. a current ~20x forward P/E and I believe CBOE’s multiple may expand back towards ~24-25x P/E once VIX volumes show a sustained inflection point and BATS synergies are revised higher

    OVERVIEW OF VARIANT PERCEPTION

    VIX Franchise Growth Prospects

    Street view: Most of the market believes that the slowdown in VIX futures and options is structural and longer term in nature. Also there is misplaced fear of potential regulatory actions (fines, mandated changes to VIX) against CBOE. Uncertainty has led to reduced VIX growth assumptions and recent short VIX ETF AUM losses are viewed by the market as structural. Sell side is modelling a ~3% organic revenue in 2019 and ~5% in 2020, despite that fact that CBOE PF organic growth has been ~8% over the past five years.

    My View: Based on my extensive company and industry research as well as VAR calls, I believe that the long-term growth prospects of the VIX franchise have not been impaired. Feb 2018 will end up being just like the Summer 2015 spike in VIX which lead to a few Q’s of volume weakness before returning to its strong historical growth rates. In addition, I have been able to refute any potential regulatory or legal concerns. In addition, I believe that the market is overly focused on short VIX ETF AUM which directly only accounts for ~5% of VIX volumes.

    I don’t believe that recent events will lead to structural lower trading volumes and I expect 6% organic revenue growth in 2019 and >8% in 2020. In addition, I believe we are getting a free option on potential acceleration of growth driven by increased market volatility and / or increased electronic trading of CBOE’s products on BATS’ exchanges as they finish integration in 2019.

    Cost Synergies

    Street view: Consensus is modeling cost synergies in line with management’s guidance ($85mn over 4 years). Yet, CBOE’s stock has only outperformed the S&P 500 by 10% since the deal was announced, despite the fact that BATS was highly accretive and CBOE’s EPS is expected to double from 2016 to 2019.

    My View: My base case assumes that management achieves >$110mn of cost synergies by 2020, driven by eliminating CBOE’s technology systems, optimizing corporate / support functions, reducing professional service fees and consolidating real estate. Moreover, much of this synergies uplift remains for 2019

    Other Free Options

    Street View: The street does not assume any additional value creating capital allocation and they don’t assume any volume uplift from new product launches and/or electrification of CBOE products

    My  View: I believe that buybacks and M&A will drive additional shareholder value (either through inorganic growth as an acquirer or as a take-out candidate). CBOE has already announced an incremental $250mm in buyback repurchase authorizations since February 2018, roughly a year earlier than consensus expectations. Moreover, CBOE stands to benefit from significant volume due to new product launches and the electrification of CBOE pit focused products.

    Overview of Implied Expectations

    Given CBOE’s non-transactions revenues will grow ~5-6%; I believe consensus is modeling flattish transaction revenues for 2019. In addition, based on consensus EBITDA estimates it implies that CBOE OpEx will grow ~7% in 2020 vs. its historical avg of low-single digits OpEx growth.

    Overview of KEY INVESTMENT FACTORS (KIFS)

    ·         KIF #1: High Quality Business with Secular Tailwinds

    ·         KIF #2: Lower VIX Volumes & Trading is Transient

    ·         KIF #3: BATS Deal is Transformative & Highly Accretive with Low Consensus Synergies Estimates

    ·         KIF #4: Free Upside Options & Many Ways to Win

    KIF #1 High Quality Business with Secular Tailwinds

    CBOE is a unique asset in terms of its barriers to entry, competitive advantages, business quality as well as its secular growth and tailwinds. In my differentiated view, CBOE represents an extremely cheap MasterCard or Visa-like network business in it early innings, where there is significant volume upside ahead with limited incremental costs associated with this uplift in revenues.

    CBOE is unlike most of exchanges as it holds the exclusive license (read monopoly) to list index options on the S&P 500 Index (SPX) as well as its own proprietary VIX Index suite of products, which together represent ~2/3 of CBOE’s transaction revenues 

    As a function of these exclusive relationships and intellectual property, the company has demonstrated considerable pricing power in its proprietary products, typically raising price 2-3% per year on average over the last few years whereas most other exchange products are seeing structural price pressure as investors can buy and sell various multi-list products such as equities and equity options on multiple exchanges. This is simply not the case for CBOE’s VIX & SPX franchises and this has allowed for continued CBOE futures price increases from already high levels while pricing on nearly every other exchange traded product has seen massive and/or continued price deflation.

    Since CBOE created the VIX as well as options and futures on this “fear gauge” in 2004 the VIX has grown from a small niche product to an asset class in itself. Long term secular adoption and usage of VIX continues to expand as more and more market participants and institutions seek unique ways to cheaply mitigate downside exposure to equity markets. Outside of S&P 500 puts, which are tied to a specific market level, VIX offers structural advantages in that it is based on an absolute level. In addition, movements in the VIX are usually multiples (5-10x) of the underlying declines in the S&P 500. It will take time for many to realize that VIX represents one of the best bangs for your buck in terms of hedging equity exposure and institutional adoption should continue to increase for many years to come. Strong growth behind VIX futures has already led for VIX futures revenue to increase from ~3% pre-BATS trading revenues to ~20% of 2017. 

    Also, while there are substitute products for hedging equity exposure, SPX options have significant economic benefits for institutional investors hedging in size. In fact, the closest alternative to SPX options costs 7x the price to trade the same notional 

    On top of this, how many businesses do you know with >60% EBITDA margins that are rising to ~70% over the next ~3 years where D&A is a low portion of the EBITDA? CBOE’s business model is highly scalable with large fixed costs and super high incremental margins (~75%) as there are low variable costs for incremental trading volumes. As such, accelerating volumes drives outsized profit growth as volumes ramp up. Furthermore, in CBOE’s Futures business, where the short term pain of weaker VIX volumes is being felt, there are even better margins as it earns >90% EBITDA margins.

    Along with monopoly like pricing power and high margins, CBOE still has tremendous growth ahead of it. CBOE futures volms have grown from ~4mn ADV to ~300mn in ADV over the last 10 years and from ~159mn to ~293mn (~2x) over the last five years. Despite this tremendous growth, CBOE is still relatively early in growing its user base, which it has accomplished through an extension of trading hours and through broad-based education of traders. In the past, CBOE reported revenue growth has been dragged down by CBOE’s non-proprietary equities business which continues to flat line and become a much lower % of CBOE’s product mix. Going forward this should be a much smaller headwind (due to its size) or even a tailwind due to greater price rationality now that CBOE owns BATS, the industry price disruptor.  In all, these proprietary products now represent ~90% of CBOE’s transaction revenues (pre-BATS deal) up from ~50% in 2010.

    As a result of this monopoly in VIX, CBOE is also uniquely positioned to monetize the proprietary data that is associated with VIX & SPX trading. However, CBOE is also in the early innings of monetizing its data as more and more investors leverage this data as a mission critical element to their trading strategies. This should allow CBOE’s non-trading revenues (~36% of sales) to continue compounding at MSD rates for the next 5-10 years and grow faster than data revenue at other exchanges which continue to grow at a LSD-MSD clip.

    Nevertheless, CBOE isn’t resting on its laurels and there are strong secular tailwinds behind some of their newer products as well. They are rolling out new products such as ETFs, bitcoin futures as well as the first ever options and futures on fixed income indices coming in August 2018 which will contribute to accelerating growth over time.

    On top its high margins, strong growth and low CapEx (~3% of sales), CBOE has also been a large beneficiary from US tax reform as they generate ~90% of revenues in the US and its tax rate dropped from 39% to ~27%. This is a recipe for strong revenue to FCF conversion and I believe that >45% of each dollar in revenue will be converted to FCF in 2018-2020.

    KIF #2: Lower VIX Volumes & Trading is Transient

    Despite CBOE’s business quality and long term secular growth, CBOE and VIX volumes have recently been under pressure as a result of the Feb 2018 VIX flare up. Many believe that the long term growth story in CBOE is permanently impaired. Based on my work, I believe this is simply not the case and this is just a speed bump in the road towards longer term growth.

    Due to the way risk/insurance is priced, the futures curve for VIX is normally in contango, meaning the future contracts trade at a premium to the spot VIX. (see below)

    When volatility or fear remains muted this future contract eventually converges with the lower spot market level allowing speculators an attractive means of profiting by shorting VIX futures. The last several years witnessed muted volatility, with near all-time lows in 2017 due to strong corporate profit growth, accommodative monetary and fiscal policy as well as limited systematic risk events like terrorist attacks. This allowed speculators to realize handsome profits as they continued to short VIX futures in increasing size. Moreover, many less experienced investors piled into this trade via the proliferation of short and levered short VIX ETFs which attracted an increasingly naïve retail base of retail investors.

    This trade became more and more crowded until the Feb. 5th VIX shock, when a small increase VIX levels led to a liquidity squeeze which rippled across the equity volatility landscape. When it was all said and done the VIX closed up over 100% on the day. While the risk off on Feb 5th was exacerbated by technical factors, the impact has continued to make its presence felt in the VIX market. This shock led to a flattening of VIX future curve as the near term/spot rose while longer dated VIX futures barely moved and this flattening of the curve remained in place for several weeks. Generally speaking, a flatter VIX curve is a headwind to volumes as there are less ways to play the VIX curve and as seen by weaker recent trading volume data.

    AUM in VIX ETF complex has also declined post the Feb 2018 spike. From >$400mn at the end of 2017 across all short VIX futures ETFs, AUM has dropped to ~$200mn. Events of Feb 5th led to the forced closure of the XIV ETF and substantial losses for the SVXY ETF. As a result of this pain, many levered ETFs have revised leverage targets lower, which has also led to less VIX buying and selling by ETFs. However, I believe this volume should return over time as contango has returned to the VIX curve. Despite this drop in short VIX ETF AUM, AUM in long VIX ETFs have held their approximate levels.

    Nevertheless, adoption of VIX has not and will not be a straight line. There have been numerous VIX spikes which have led to the harvesting of VIX “insurance policies” as well as a subsequent short-term flattening of the VIX futures curve. As was the case in August 2015, it is common for large short-term spikes in VIX to lead to a short-term reduction in VIX trading volumes and open interest. Post the August 2015 spike the VIX call option open interest declined by ~50%, but it gradually recovered as volatility normalized. In the case of 2015 it only took a few quarters until VIX volumes began rebounding and continuing towards their long-term secular growth. I believe it is only a matter of time before this will happen again given the secular tailwinds associated with the VIX asset class. Even during the financial crisis volumes in the VIX suite proved their resiliency and grew despite the macro headwinds.

    The rebalancing of these short VIX ETF flows, which has been a source of volume headwinds, is near complete and levered VIX ETFs have normalized at ~5% of daily volumes vs a previously estimated ~10% of volumes. Despite this VIX headwind, however, SPX volumes have picked up as traders have shifted from using VIX to SPX options to hedge market price movements.

    Moreover, the speed and magnitude of the pain on the short VIX community was unprecedented and led many to cite conspiracy theories around whether the VIX was broken, manipulated or even flat out fraudulent. After speaking with former regulators, exchange executives and industry experts, I believe this VIX spike confirmed two things: 1) VIX as an asset class is in its infancy and demand can easily overwhelm supply (or vice versa) due to an immature market structure and 2) there is a long way to go in terms of investor education around what VIX is and how it works.

    CBOE is addressing these concerns as they have brought more market makers into the VIX settlement, which will make for deeper liquidity, more efficient pricing and higher volumes in the future. Also, while there were many short VIX investors that lost a lot of money, I can confirm that there was nothing nefarious, illegal or broken about the VIX and how the asset class is priced and I believe this risk will be extinguished as time passes.

    As was the case with credit cards, they were once seen as very dangerous and fraught with risks before education was established and they soon became useful financial tools for the masses. I believe that hedging and the use of VIX as an asset class could similarly be just in its infancy as an asset class and time and education will similarly lead to long term growth and adoption of this new financial product over time.

    In addition, there are many downside mitigants in the near term as we wait for VIX volumes to rebound. VIX and SPX are complementary assets and a flat VIX curve has led many traders to increase their volumes in SPX options instead as evidenced by strong index options volumes in Q2. In addition, market participants have already seen the benefit of early CBOE product transition on to the BATS exchange and management expects August 1st pricing changes will provide modest growth off the Q2 base.

    Lastly, while many see lower VIX ETF volumes as a structural risk for lower VIX demand, I believe this is circular and more of a lagging proxy for VIX demand rather than the cause for lower VIX trading volumes. Open interest in the VIX has already bottomed and continues to build as the VIX curve has normalized (returned to contango) and many investors return to seeking VIX exposure.

    Encouragingly, VIX futures open interest has increased by 23% since the end of July and now sits at its highest level since February. In addition, month-to-date average daily volume (ADV) is up 27% from July levels and on pace to be the contract’s best volume month since March. Also, August month to-date ADV for VIX options is up 30% from a very soft July and open interest appears to have stabilized. While both volumes and open interest remain well below pre-February levels, the stability and growth in these contracts are signs that we have potentially reached a positive inflection point in terms of VIX trading volumes

    KIF #3: BATS Deal Transformative & Highly Accretive

    In September 2016, CBOE announced that it would acquire BATS for $3.5bn, equivalent to 13x 2016 EV/EBITDA, or 10.5x including original targeted synergies of $65mn over ~5 years (by 2021). The deal closed in March 2017 and was financed low-cost debt (~3% cost) and ~20mn CBOE shares which allowed the BATS management team to participate in upside

    In acquiring BATS, CBOE acquired the best and structurally advantaged (cheapest and fastest) exchange platform. One of the main motivations was for CBOE to put its best in class products on BATS’ best in class exchange technology. Before this acquisition, CBOE had a remarkably high ~50% of its trading volumes coming from antiquated open pit trading vs. BATS ~100% electronic volumes. BATS was originally founded in 2005 as a consortium effort financed by broker-dealers and trading firms to provide a low-cost alternative to the dominant U.S. equity exchanges (NYSE and NASDAQ). BATS built its electronic-only exchange on scalable Linux-based technology and this, coupled with its geographically-advantaged footprint in Kansas City, allowed BATS to price transaction fees at a massive discount to incumbents which led to significant share gains in cash equities and multi-list equity options. For example, standalone BATS was able to price trades for U.S. equities and multi-list options at a ~50% discount to Nasdaq / NYSE and this disruptive pricing drove BATS equities market share from ~0% in 2006 to ~20% today.

    Furthermore, BATS’ trading platform experiences very low operational downtime and low latency vs. CBOE’s platform and other electronic exchanges. This reliability, capacity and speed allows for faster trades, which can lead to increased volumes by traders who were previously deterred from trading on CBOE’s old inferior electronic platform which frequently had latency issues.

    Interestingly, the BATS acquisition should be viewed more like a reverse-merger in that the BATS’ team will be running the integration process / synergy effort. The BATS management team (Chris Concannon and Chris Isaacson) has significant M&A experience as they have completed three acquisitions in the last seven years and they have a strong track record of materially beating synergies guidance.

    In general, exchange acquisitions are highly accretive to cash earnings given more volume spread over a fixed cost base and I believe management’s original cost synergy guidance of $65mn over 5 years understates the magnitude of synergies and overstates the timeline. The original target of $65mn only implied 34% of BATS’ OpEx base vs. ~70% OpEx savings achieved by the BATS team in historical deals. Furthermore, I believe the correct way to look at it is really as a function of both BATS’ and CBOE’s OpEx cost base combined. CBOE guided that ~70% of synergies will be derived from eliminating CBOE’s technology systems and the rest will come from optimization of corporate / support functions, reducing professional service fees and consolidating real estate in New York and London.

    In its first year (2017), management already ran well ahead of its initial synergy targets ($33mm run-rate vs. $15mm target). Management has now guided towards $85mn over 4 years (by 2020) but I think it will be >$110mn over ~3 years. Based on my analysis, CBOE should be able to easily eliminate >$30mn of professional fees and >$20mn in duplicative systems expenses once CBOE’s exchanges are migrated to BATS’ technology. For more color on BATS synergies please refer to the Appendix. Ultimately, the BATS transaction will be ~80% accretive vs. standalone 2019 CBOE EPS as the company outperforms its cost synergy targets.

    Moreover, most of the cost synergies are yet to come as the largest CBOE products won’t be moved on to BAT’s exchange until October 2019 when all systems will be fully integrated. This is expected to yield significant cost synergies and potential revenue synergies from a more efficient platform with better complex order handing. BATS has the lowest cost structure (OpEx and CapEx) in the industry and much of CBOE’s legacy support costs will be eliminated once the migrations are complete. This will lead to significant margin expansion and a synergies surge in 2019. Lastly, CBOE hasn’t provided any revenue synergies targets, but they could be significant as electrification of other exchange products historically has led to large increases in trading volumes.

    KIF #4: Additional Upside Options for FreE

    Revenue Synergies

    On top of cheap valuation for a very high quality business, CBOE stands to benefit from significant potential revenue / volume benefits due to 1) further electrification of CBOE index options once they are migrated to BATS’ technology platform 2) cyclical upside in volatility as the Fed and others continue raising interest rates 3) the potential to leverage BATS’ European sales force to cross-sell CBOE’s proprietary products 4) a more rationale pricing environment as CBOE has eliminated the main disruptor in the multi-list equity options market and 5) new product introductions including bitcoin futures, ETF listings and fixed income index futures and options.

    Prior to the BATS transaction CBOE was unique in that it had a weak electronic trading platform and ~50% of volumes remained fit traded. As CBOE moves its products onto BATS’ platform CBOE products should see a volume uplift as similar products have benefitted from a ~25-50% uplift once products move from open outcry to electronic ordering. Due to the early success in transitioning CBOE products on to the BATS’ backbone, CBOE has commented that this has already led to larger sized bid-ask orders as traders benefit from better trading systems, improved order book depth and lower latencies. While I don’t give them any credit for volume/revenue synergies, this is also not baked into any of the consensus estimates

    Industry Consolidation Winner

    Given its <$11bn market cap, CBOE remains the last needle moving acquisition candidate in the global exchange space as consolidation nears its end. Due to large synergies available when exchanges merge there has been over ten years of consistent M&A and just a handful of global exchanges remain with strong product and geographical diversity.

    Anti-trust / competition concerns are already front and center and has already led to the rejection of LSE’s acquisition of Deutsche Bourse in 2017. Given that CBOE’s proprietary VIX & SPX franchisees has limited product overlap with other exchanges there is limited competition risk outside of US equities. Moreover, as CBOE doesn’t own strategic geographical equity exchanges there is little risk that politicians would move to block the acquisition of CBOE as politicians have done in the case of the ASX/Singapore and others have threatened to do so in the case of a few other local equity exchanges

    In the past CBOE shares have garnered an appropriate take out premium in its multiple due to its scarcity value and its ability to court multiple suiters, but this no longer exists as CBOE hovers at ~20x forward P/E or its lowest valuation in five years. It has long been rumored that CME might acquire CBOE and consolidate the two complimentary Chicago exchange powerhouses. In regards to product overlap this is limited in the case of CBOE/CME. While CME has particular strength in commodities and fixed income, CBOE boasts the unique VIX and SPX franchises, equities, multi-list equity options and forex. On top of this LSE, remains well capitalized and highly interested in yet another needle moving deal as its DB takeover was blocked. Finally, ICE, which has a long history of aggressive M&A under CEO Jeff Sprecher, is not a buyer that should be ignored as they have historically been a serial acquirer. Furthermore, it has been several years since ICE’s last large acquisition. However this deal would probably require ICE to divest CBOE’s equities business as ICE already controls the #1 US equity exchange in NYSE. This seems easily do-able and would likely solicit interest from multiple strategic suitors

    As investors wait for VIX volumes to rebound, I believe CBOE’s valuation has limited risk of falling much below 20x as it would just lead to an opportunistic buyout by one of the many exchanges seeking the one last needle moving acquisition that is available in the consolidated global exchange industry.

    Increasing Capital Allocation

    In addition, CBOE investors get additional upside from capital allocation as free upside. Prior to the BATS deal, CBOE had retired ~15% of its shares from 2010-2016, or ~3% of shares per annum. Upon announcing the BATS deal, CBOE put buybacks on hold as its ND/EBITDA leverage ratio briefly hit >2.2x. Management guided towards not returning to capital allocation until they had paid down the BATS bonds which implied that capital allocation would be on hold until 2019. However, CBOE has been a large beneficiary of corporate tax reform and this allowed for more accelerated debt pay down.

    CBOE has already delevered to a conservative <1.5x ND/EBITDA and on the backs of this transient share price weakness CBOE has already initiated $250mn of buybacks since Feb 2018, or nearly one year ahead of expectations. The earlier-than-anticipated buyback program announced in February 2018 signals optimism and comfort around running a levered balance sheet (previously net cash).

    The company has historically allocated ~80% of its FCF to buying back stock and paying dividends but if management were to maintain ~2x Net Debt/EBITDA leverage profile this would provide ~10% of additional upside

    Moreover, CBOE sits at a sweet spot within the exchange industry as it is small enough to be a takeout candidate for many larger suitors, but it’s also large enough to roll up various regional exchanges using the BATS’ platform. BATS’ team brings a new expertise in capital allocation and M&A integration. BATS has grown its business through a series of highly successful acquisitions, expanding into other geographies and asset classes. Now that BATS’ technology will be run on CBOE’s exchanges, there are still several regional stock exchanges that could be targets / tuck-ins. VAR suggests that former BATS CIO (current CBOE CIO) has developed an easily replicable blueprint for migrating exchange technologies to the BATS platform. In each instance, once technology integration occurred, BATS was able to substantially reduce headcount and technology-related expenses allowing for highly accretive M&A

    Product Launch Upside

    CBOE also has a long history of product innovation including the advent of VIX and its product suite. CBOE has continued to be aggressive in new product launches and were one of the first to launch bitcoin futures in late 2017. In addition, CBOE expects to launch iBoxx corporate bond futures later in August 2018 (Q3) with first a HY index and then an IG index. This is the first exchange traded futures product linked to broad corporate bond indices and with Blackrock’s buy-in this should create long term volume tailwinds especially as new fixed income options and futures products ramp over the next ~12 months. The Corporate Bond Index Futures contracts with options & futures also has strong support from largest FI investors / ETF providers (Blackstone, State St, etc.

    All of the above catalysts provide free upside to CBOE’s share price and provide investors many additional ways to win that is not included in consensus estimates.

    MANAGEMENT OVERVIEW

    Edward T. Tilly.  Mr. Tilly is our Chairman and Chief Executive Officer. Mr. Tilly has served as our Chairman since February 2017 and as CEO and director since May 2013.  Prior to becoming CEO, Mr. Tilly served as President and Chief Operating Officer from November 2011, and Executive Vice Chairman from August 2006 until November 2011. He was a member of CBOE from 1989 until 2006, and served as Member Vice Chairman from 2004 through July 2006. Mr. Tilly serves on the board of directors of the OCC. He holds a B.A. degree in Economics from Northwestern University.   

    Christopher R. Concannon.  Mr. Concannon is our President and Chief Operating Officer, a position he was appointed to upon the Company’s acquisition of BATS.  Previously, he served as BATS’ President since December 2014, director since February 2015 and CEO since March 2015. Prior to joining BATS, Mr. Concannon was most recently a president and chief operating officer at Virtu Financial, a global electronic market maker, from 2009 to 2014.  Mr. Concannon holds a B.A. degree from Catholic University, an M.B.A. degree from St. John's University and a J.D. degree from Catholic University's Columbus School of Law.

    Brian N. Schell.  Mr. Schell currently serves as our Executive Vice President, Chief Financial Officer and Treasurer, a position he has held since January 1, 2018. Previously, he was Deputy Chief Financial Officer of the Company’s subsidiary CBOE Exchange, Inc., a position he was appointed to upon the Company’s acquisition of BATS.  Prior to that, he served as Chief Financial Officer of BATS since March 2011. Prior to joining BATS, he held various senior leadership positions at H&R Block Inc., as well as various positions at the FDIC, KPMG and JP Morgan. Mr. Schell holds a B.B.A. degree with an emphasis in finance from the University of Notre Dame and an M.B.A. degree from The George Washington University.     

    Christopher A. Isaacson. Mr. Isaacson is our Executive Vice President and Chief Information Officer, a position he was appointed to upon the Company’s acquisition of BATS.  Previously, he served as BATS' Executive Vice President and Global Chief Information Officer since February 2014 and he has held other various senior leadership positions since 2005.  Prior to being one of the founders of BATS, Mr. Isaacson was a software developer at Tradebot Systems, Inc. from 2003 to 2005. Mr. Isaacson holds a B.S. degree in information systems with a minor in math from Nebraska Wesleyan University and an M.B.A. degree from the University of Nebraska-Lincoln.    

    CAPITAL ALLOCATION OVERVIEW

    Until CBOE acquired BATS for $3.5bn in March 2017 the company had run with net cash and frequently bought back shares at a rate of 2-3% of shares outstanding per annum. On top of this CBOE pays a nice dividend of $1.24/share per share (~1.3% yield), which has continued to increase by 10-15% per annum. Going forward dividends are expected to grow in-line with EPS and continue to increase by 10-15% y/y per annum.

    However, as stated above, in February, post VIX flare up, CBOE re-instated its buyback (~1 yr early) with a $150mn authorization before adding another $100mn authorization in August 2018. Company is only levered ~1.4x ND/EBITDA and despite modeling increasing buybacks, assuming buybacks of $290mn in 2018 and $500mn in both 2019 and 2020, CBOE will only be levered ~1.1x 2020 YE

    CBOE Top Holders

    ·         Hedge Funds own ~12% of shares

    ·         BoD holds ~1% of shares

    ·         Long time CEO Ed Tilly only owns ~100,000 shares

    ·         While potential successor, Concannon Chris owns >150,000 shares and recently bought ~10,000 shares in the open market on May 30th.

    SENTMENT

    ·         Sentiment is still mixed with many skeptical holds and few buy ratings

    ·         Sell side #s have come down over the last six months as they are modeling long term growth headwinds in CBOE’s VIX product suite

    Estimates vs. Share Price Analysis (EEG)

    ·         CBOE share price is -25% whereas 2019 EPS estimates have declined by ~7%

    ·         Much of this share price weakness has been relegated to multiple contraction as the buyside has lowered its numbers below consensus levels.

     

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise do not hold a material investment in the issuer's securities.

    Catalyst

    Rebound in VIX volume. Higher than expected BATS synergies

    Messages


    SubjectQuestions
    Entry08/23/2018 10:12 AM
    Memberavahaz

    Supersny,

    Thanks for the write-up. I haven't looked at CBOE closely because it always seemed to me that they are overrated relative to peers as US options and European/US cash equities are the most commoditised segments of global exchanges. What % of CBOE revenue and earnings is derived specifically from VIX trading and data? 

    Regarding the S&P500 contract, i believe that IP is owned by SPGI and CBOE is just a contractor. What allows them to extract attractive economics from this given SPGI could otherwise award the contract to any of the dozen other US options exchanges?

    Also, don't you think the heavy concentration of the quality here on a single franchise (the VIX) which happens to be by definition a very volatile franchise warrants some kind of discount to peers that posses a much wider array of unique IP?

    Lastly, what are the potential regulatory actions that you are referring to that investors are fearful of?

    Many thanks!

     


    SubjectRe: Re: Questions
    Entry08/23/2018 10:25 AM
    MemberSpocksBrainX

    p.s.  that spy question is a good one.  From the K:

    S&P 500, S&P 100, S&P Select Sector Indexes.

    We have the exclusive right to offer options contracts on the S&P 500 Index, the S&P 100 Index and the S&P Select Sector Indexes as a result of a licensing arrangement with S&P Dow Jones Indices, LLC (“S&P”). Our license with S&P is through December 31, 2033, with an exclusive license to trade options on the S&P 500 Index through December 31, 2032. We are also authorized to use the S&P 500 Index and S&P 100 for the creation of Cboe volatility indexes, such as the VIX Index, and tradable products on those volatility indexes.


    SubjectRe: Re: Questions
    Entry08/23/2018 10:30 AM
    MemberSpocksBrainX

    sorry, looking at this real time - very interested in this idea

    looked at another way though - also in the K:

    We hold exclusive licenses to list securities index options on the S&P 500 Index, the Russell 2000 Index, as well as others, granted to us by the owners of such indexes and based on which we have developed our proprietary VIX methodology. In 2017, approximately 69.8% of our net transaction fees (defined below) were generated by futures and index options, the overwhelming majority of which were generated by our exclusively-licensed products and products based on the VIX methodology. 

    (trans were 70% of revenue as noted)


    SubjectRe: Questions
    Entry08/23/2018 07:41 PM
    MemberSupersny

    Avahaz - good ?s thanks.

    In 2017, Trading was ~64% of revenues. Of this ~17% equities and ~10% multi-list options. So in total you have ~17% of total revenues coming from "commodity" exchange products. The reason they are commoditized and prices have raced towards 0 is because these are all multi-list products. Meaing you can buy them and sell them on any exchange. BATS was actually the worst disruptor for the industry as they came in several years ago and started pricing at ~50% less than NYSE and NDAQ. Now CBOE is going to be able to use BATS systems for trading of CBOE products!

    CBOE would never argue that a reason for buying BATS was to eliminate the "disruptor", but I wouldn't be suprised if equity pricing bottoms out here given its already close to $0 and now the market is controlled by just 3 players.

    Most of the rest of CBOE trading revenues come VIX & SPX where they are exclusive products to CBOE. Meaning you can't buy them on CBOE and close them out somewhere else. This allows for greater pricing power and not a race to the bottom. CME has S&P mini's which are similar, but much more expensive to trade in size. This is why CBOE continues to dominate S&P derives space.

    Yes, CBOE does liscense S&P from SPGI and they pay a fixed royalty rate to SPGI. They have this for another 15 yrs. ISE had tried to create a competitor product years ago and CBOE sued. The courts upheld CBOE's (and CME's) monopolies. SPGI could perhaps ask for more $, but this is in 15 yrs. CBOE will print a lot of money before this mattters in 12 years. Also, SPGI get paid based on volms. The network effect is already well established on CBOE. 

    Your question as to whether this should trade at a discount because of its VIX/SPX concentration? I think that depends on your view of the VIX. I wish this could be ~100% VIX but that is because the VIX complex is growing at ~25% CAGRs for the last 5 yrs. I think the VIX volume easily be 2x what it is now in 5 yrs.

    I dont want them to diversify into slower moving products or asset classes.

    Once again CBOE has exclusives on S&P options and the entire VIX franchise - both are seeing massive secular growth as the world moves to more and more passive investing, while volumes and pricing at other asset classes like multi-list see race to the bottom pricing and/or mature participation rates.

    Equities aren't a growth asset class as 100% of people know they can buy stocks and how they work.

    Part of the compelling thing about CBOE and VIX is that this is an asset class in its infancy and participation even amongst institutional long/short HF's remains very low.

    Regulatory stuff has no meat on the bones. Happy to address furthur but if anything Barclays might be at risk. Not CBOE.

     

     

     

     

     

     

     

     


    SubjectRe: Re: Questions
    Entry08/30/2018 10:11 PM
    Memberima

    Have you tried to size the IBOXX opportunity? 

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