We believe that the Chicago Board Options Exchange (Ticker: CBOE) is an incredibly compelling long opportunity at today's levels, which offers somewhere between 30-100% upside based on our models.  The Company boasts an advantaged business model with proprietary monopolistic products (~50% of transaction revenue), strong growth prospects, and high returns on invested capital.  Additionally, the cheap valuation and motivated management team make CBOE a particularly attractive consolidation candidate.   Investors have long been attracted to the operating model of financial exchanges due to their capital light, proprietary nature that has historically afforded substantial pricing power and monopolistic, annuity-like economics.  However, in recent years, several exchanges which were accustomed to operating in defensible markets with wide moats have begun to experience substantially more competition, serving to drive down transaction fees as rival exchanges push aggressively for additional market share.  This is particularly true of exchanges primarily focused on more commoditized asset classes, including equities and options on equities/ETFs.  It is our belief that the CBOE is currently being misinterpreted by the market as a commoditized exchange operator that will continue to succumb to the competitive pressures taking place within the industry given their substantial presence in the equity and ETF options arena, placing substantial pressure on the Company's share price of late.  We believe that investors will eventually recognize the substantial earnings power and growth inherent in CBOE's business model, and the stock will re-rate substantially higher.

Business Overview:

The CBOE was founded in 1973 through a spin-off from the Chicago Board of Trade as a not-for-profit exchange, creating the first listed options exchange in the U.S. In June of 2010, the Company demutualized and listed its shares on the NASDAQ. In the face of fierce competition over the years, CBOE has relinquished considerable market share, but remains the market leader for U.S. options industry volume with approximately 28% market share today. As an exchange, CBOE operates markets for the execution of transactions in equity, index and ETF options, including proprietary products, such as S&P 500 options (SPX), the most active U.S. index option, and options on the CBOE Volatility Index (VIX). CBOE's Hybrid Trading System incorporates electronic and open-outcry trading and is powered by CBOEdirect, a proprietary, electronic platform that also supports the C2 Options Exchange (C2), CBOE Futures Exchange (CFE), CBOE Stock Exchange (CBSX) and OneChicago, various exchange subsidiaries owned by the Company. Transaction fees are the primary source of revenue for the Company (~75% of total revenue) and represent fees paid to the exchange on a per contract (volume) basis and vary widely depending on the product and type of transaction. Approximately half of transaction revenue comes from index options (primarily SPX and VIX) and the rapidly growing VIX futures exchange, while the remaining half comes from options on individual equities and ETFs. The remaining 25% of consolidated CBOE revenue comes from non-transactional sources such as access fees charged to trading permit holders, exchange services and other fees such as equipment rental, maintenance services, and market data fees.

While the options exchange industry has faced pricing pressure from competition in the more commoditized products such as options on ETFs and individual equities, overall volume growth continues to more than offset pricing pressure. Even as the Company has relinquished market share over time, it has managed to consistently grow revenue and operating income at double digit rates through volume growth (18% compounded annual growth since 2000 vs. 21% for the entire industry) and from a shift in its business mix to more proprietary, higher rate per contract products.  From 2006 through 2010, revenue and operating income grew at a compounded rate of 14% and 25%, respectively, and in 2011, these figures are growing at an even faster rate. As an exchange, CBOE benefits from substantial operating leverage and as top line growth is beginning to accelerate, we anticipate that margins will grow as well, with EBITDA margins expected to be north of 50% this year. Part of the beauty of the business model is that the customers are among the largest shareholders of the Company (yet are not employees), incentivizing them to generate additional business for the exchange, which requires very small incremental variable costs. Notably, these same customers comprise the new products committee, and have helped the exchange lead the industry in innovation through creating products such as VIX futures and options.

The VIX was developed by the CBOE in 1993 to measure implied future volatility derived from options on the S&P 500, an important output from the commonly used Black Scholes options pricing model, and is often referred to as a "fear gauge".  CBOE has exclusive rights to this product through trademarks and patents. While the VIX has officially been in existence for about 20 years, VIX futures and options were both introduced in the last several years. VIX futures were first listed in March 2004, followed by VIX options in February 2006.  During their first couple of years, both products had very limited volume, but have grown prodigiously since 2008 and now represent nearly 20% of CBOE transaction revenue. The huge growth in Exchange Traded Funds and Notes (ETFs and ETNs) which are linked to VIX instruments continues to drive additional liquidity to these markets. Importantly, the proprietary ownership of VIX affords CBOE much greater pricing power, allowing them to charge approximately $0.50 per VIX option contract and approximately $1.50 per VIX future, significantly higher than the $0.15 to $0.20 they earn on equity and ETF options.

The rapid development of the VIX franchise in the past few years has effectively elevated volatility trading to its own asset class, and all different types of industry practitioners have incorporated VIX instruments into their trading/investing repertoire. VIX prices tend to be inversely related to the overall direction of the market, so they are used by many portfolio managers as a hedge against uncertain markets environments. The CBOE is constantly developing new ways to implement and monetize VIX, including licensing it to other domestic exchanges such as the CME, and foreign equity markets such as Euronext, Taiwan Futures Exchange, National Stock Exchange of India, the Australian Stock Exchange, TMX Group, Inc., and Hang Seng Indexes. The CBOE is also creating single stock VIX for heavily traded equities such as Apple, Goldman Sachs, and Google.  Although these are likely longer term projects, we believe they will begin to contribute materially to revenue over the next few years.  As can be seen in the chart below, VIX trading volume growth has been off the charts, and we see no reason why volume won't continue to grow at a healthy clip.  It is worth noting that while volume tends to spike during times of distress, the growth in VIX is not driven entirely by market downturns, given that the S&P is up ~54% from 2009 through 2Q11. 

SPX Options are another product where the CBOE has exclusivity, and therefore higher prices per contract.  The Company has an exclusive license from S&P through 2017 on SPX, which allows them to maintain market leadership in index options.  However, a number of competing alternatives are available, such as options on the SPDRs (SPY), and e-Mini S&P500 futures options that provide exposure to essentially the same instrument.  These alternative products have limited growth in SPX options, and trading volumes have remained steady over the last few years.  SPX options currently comprise approximately 30% of transaction revenue, and the CBOE earns approximately $0.65 cents per contract. While we have no reason to believe that they are in danger of losing this license, and have successfully defended this arrangement against litigation brought to them by the International Securities Exchange (ISE), a competing options exchange, this product is unlikely to witness the explosive growth seen in VIX.  The CBOE is also in the process of launching a new all electronic version of SPX options, called SPXpm.  These options will be identical to SPX options except they will have end of day settlement, rather than the beginning of the day.  We are hopeful that this new product will drive additional trading volume to CBOE, however due to the many similar competitive instruments, we are cautious in our expectations.

Equity and ETF options, on the other hand, are a commoditized product, and there is essentially zero differentiation between trading those options at the CBOE, or at any other options exchange.  There are slight disparities in their respective fee structures, however most market participants who trade options will not even see those differences, because they are lumped in with their brokerage commissions.  In addition, because of National Best Bid / Offer (NBBO) regulatory requirements, no matter where a trade is executed there is no price advantage to trading at a given exchange.  Despite the lack of differentiation in equity and ETF options, the CBOE continues to compete aggressively, including the introduction of C2, their entirely electronic exchange, in late 2010.  C2 differs from CBOE in that it uses the popular make / take fee structure, rather than a flat fee per contract.  While the CBOE has slowly lost market share due to aggressive pricing tactics from competing exchanges, their overall volume in these products has been fairly stable over the last few years, and is still up substantially when compared to several years ago.

Valuation Overview:

At its current price of $22.52/share, CBOE has a market capitalization of $2.03 billion, and with $116 MM of cash on their balance sheet, and no debt, an enterprise value of $1.91 billion.  At ~7x 2012E EBIT, shares of CBOE offer a highly compelling value proposition to buy into a business that consistently generates returns on invested capital north of 100% and has among the industry's most innovative management teams and best growth prospects, principally through its proprietary suite of VIX products.  Additionally, the Company has a strong history of returning excess cash to shareholders.  In fact, they went public not because they needed additional cash, but rather to create a liquid market for their shareholders, which consisted primarily of options traders who owned seats on the exchange.  In 2010, they returned nearly $400 MM to shareholders in the form of a tender offer at $25 / share and dividends.  It is worth noting that the remaining 38 MM shares that were locked up post IPO are now freely trading, as of June 13.  Management announced on August 2, 2011, a $100 MM share repurchase program, as well as an increase in the quarterly dividend to $.12 / share.  This announcement highlights management's willingness to return capital to shareholders, as well as the cash generative nature of the exchange business.

Although we find CBOE to be incredibly compelling at its current valuation as a standalone public company given its growth opportunities and returns on invested capital, we also think it is very likely to be a takeout candidate in the coming years. Within the exchange space, there has been a trend of continued consolidation between competing entities.  These consolidations are very accretive transactions, primarily through the economies of scale and synergies that the exchange is able to achieve.  While these factors are often cited in any acquisition, they are particularly applicable in this case.  According to a recent Stifel Nicolaus report, the expected cost savings to an acquirer of CBOE could be as much as $95 MM / yr in the event of a takeover, or ~35% of current expenses, due primarily to headcount and technology redundancies.  This would improve this year's EBIT by nearly 50%. Therefore, from the perspective of a potential acquirer, shares currently trade for approximately 5.1x 2012E EBIT, leaving plenty of room for a potential acquirer to pay a healthy premium. We discussed this figure with CBOE management, and while they would not commit to a specific figure, they commented that analysts have historically been fairly accurate when estimating expense reductions. 

The most recent example of a major options exchange being acquired was the 2007 acquisition of ISE by Eurex AG, for ~$2.8 billion.  This valued ISE at 28X EV / EBIT and 11X EV / Sales.  ISE is currently the second largest options exchange in the US by volume, however it does not have the advantage of the lucrative exclusive contract on SPX, or the fast growing VIX contract, and instead is concentrated almost exclusively in the commoditized Equity and ETF options market.  Eurex predicted at the time of acquisition that they could reduce operating expenses by $50 MM / year.  This compares to total operating expenses in the prior fiscal year of $89 MM total, or nearly a 60% savings.  This example in particular gives us some confidence in the expected synergies that an acquirer of CBOE would be able to realize.

According to SEC filings, the management team of CBOE is also well incentivized to sell the business, and their compensation is structured to align their interests with those of shareholders.  Senior members of management are required to hold a multiple of their annual salary in CBOE stock.  Additionally, there are incentives in place for a change of control.  Although the numbers vary, we can use CEO Bill Brodsky as an example.  He is required to hold 5x his current salary in CBOE stock, which comes to $7MM.  Additionally, he will be paid a severance package totaling nearly $5MM in the case of a change of control.  Therefore, we believe that the management team will be highly amenable to selling the company to another exchange should the right offer cross their desk.  Many exchanges have been suggested as possible buyers of CBOE, including CME Group, Deusche Bourse, and ICE.  While our thesis is not predicated on a potential buy-out of CBOE, we believe the reasons listed above make the company an attractive consolidation target.

At current levels, an investment in the Company offers substantial upside over a medium to long term horizon.  The rest of the publicly traded exchanges in the US trade at an average of ~9X EV / 2012E EBIT.  We believe the Company has better pricing power and stronger growth prospects than most other listed exchanges, with the possible exception of CME.  Therefore, the Company should at least trade in line with its peers.  At these levels, CBOE would be trading at ~$29 / share, a 30% gain from current prices.  We also compare the Company to the market as a whole, which is currently trading at ~10.5X EV / 2012E EBIT, which would put CBOE stock at ~$35 / share.  Our upside scenario is based on a potential takeout of the company.  In this case, we look at synergy and cost reduction adjusted EBIT, which we project would be $378 MM.  If the Company were taken over at a market multiple of 10.5X EV / EBIT, a buyer would be willing to pay ~$46 / share, basically double today's prices.  As we discussed above, we believe this is a highly likely scenario, and believe that continued exchange consolidation will result in a handsome payoff for shareholders of CBOE.