RealMoney Silver - CME and Nymex Look Like a Winning Pair

CME and Nymex Look Like a Winning Pair
By Daniel Dicker
TheStreet.com Contributor
3/24/2008 3:00 PM EDT

There's not a lot I have been getting excited about in this market right now, but the commodity exchanges continue to grow at an outstanding pace, and I believe they represent a real opportunity. I'm going to give you a little history and insight and hopefully steer you into a great investment, especially in light of a recent merger announcement.

Last week, the CME Group, parent of the Chicago Mercantile Exchange, announced a final proposal for merging with Nymex Holdings (NMX) , parent to the New York Mercantile Exchange. Having been a member of the Nymex for 25 years, I have some history and insight into this proposed consolidation and a few ideas on why this stock might be a great investment today.

The November 2006 IPO of Nymex was one of the most storied offerings during a crazed period of new issues. Nymex shares, which were set at an initial price of $59 for their debut, closed that evening at $133, making this the most successful IPO of the year.

That exuberant share-price jump spoke to the astronomical rate in the growth of futures trading worldwide and the ongoing theme of consolidation among exchanges, with Nymex's strong offerings of energy and metals contracts representing the crown jewel. While takeover rumors circulated throughout 2007, share prices continued to represent high premiums to potential suitors, and nothing substantive was ever announced.

The recent swoon in the markets has hit higher-multiple growth stocks harder, and NMX shares have dipped substantially, trading into the high $70s at one point while stabilizing more recently in the mid-$80s. This dip has created the consolidation opportunity that suitors have been waiting for.

And among the many possible suitors mentioned in the past, CME Group has always stood alone as the most logical partner for Nymex. For CME's part, it has waited a long time to add the energy and metals piece of the puzzle to its established array of derivative products. While the CME's total volume numbers today far outstrip the volume that Nymex trades, crude oil and gold continue to take center stage in the commodity boom, and trading in those products shows continued strong growth. With those offerings, CME would have no remaining gaps in its dominance of the futures markets.

Further, Nymex continues to rely on CME's Globex system for matching its off-the-floor portion of electronic trade, making a different potential partnership much more difficult to execute. But this licensing agreement is not the only reason this merger makes so much sense. The synergies that would result from combining the two exchanges are equally compelling. The CME and Nymex systems of clearing are almost exactly the same and would lead to an easy consolidation.

Even their "personalities" are alike. Both exchanges have histories deeply rooted to the floor-trading communities that fueled their growth. While this has changed somewhat since they became public companies, their swashbuckling, independent spirits remain compatible.

From Nymex's point of view, a successful merger would give it the strength of a better-financed company to pursue technology enhancements. CME has also developed deeper ties to Washington, a proven leadership team and a well-documented plan for growth.

As part of the stronger CME, Nymex could finally be able to sink its rival Intercontinental Exchange (ICE) , which has surprisingly grown at an equal pace alongside of Nymex despite having similar product offerings on an inferior platform. While rumors of possible merger combinations have continued to surround Nymex through its short publicly traded life, only one relationship has really made any sense, and that is the one that was finalized last week with CME.

While share prices of both exchanges are down substantially from their highs, CME will still pony up a fair premium for NMX stock. This is how the math will work, using closing prices of Friday, March 2: At the proposed buyout ratio of 0.1323 shares of CME stock plus $36 in cash, with CME trading at $472, NMX shares would get a cash/share swap equivalent to $98.45 per share. And here is where the opportunity for investors may lie.

CME shares have become far cheaper, having traded above $700 as recently as December. At $472, the current multiple on CME shares is down to a more reasonable 31. At a completed price of $98.45, NMX shares are being bought at close to a 40 P/E, a robust takeover premium considering that NMX and CME shares can be used as excellent sector comparisons. Meanwhile, shares of NMX closed on Friday at $89.51, a nearly $9 discount to the announced takeover target price. Why the large discount?

Two problems loom, both of which I am convinced will not materialize. One is with the membership, or "trading rights," portion of the deal with Nymex, which needs concurrent approval from holders of those rights for the merger to be approved. Some holders of those trading rights do not feel that the premium being paid ($612,000 per seat) to purchase those memberships is significant enough, although I'm not yet convinced that this dissent represents the 25% of seat owners that would be needed to scuttle the deal.

The second problem involves getting approval from the Department of Justice for the merger, a process most thought would be an easy hurdle after the CME-CBOT merger was approved last year. But this became less sure after an ill-timed and irresponsible comment letter from the DOJ outlining concerns it had with the antitrust nature of vertical futures clearing wiped out $6 billion of market equity in the exchange stocks in a single day in early February.

No one is sure whether this letter represents a fresh desire on the part of Justice to revisit questions on clearing it had satisfied in the CME-CBOT merger process a bit more than a year ago. I believe, however, that in the present environment of "creative" bank structuring of products in unregulated and suspect derivative markets, the DOJ will have other more important fish to fry than re-examining a system of clearing that has been efficiently working, growing and providing deep and real liquidity -- but we'll have to wait and see.

Should these two issues prove manageable and the merger between NMX and CME proceed, I believe you're looking at quite a good investment opportunity. By buying NMX shares today while banking on the merger tomorrow, you are in essence buying CME shares at a practical discount while participating in the buyout premium. A back-of-the-envelope calculation gives the combined company an accretive gain of as much as $200 million a year in cost savings and enhanced growth.

And the timing seems right as well. Looming buyout rumors and perhaps unsustainable growth expectations that added huge premiums to exchange stocks until recently have mostly disappeared, making these stocks a lot more attractive, using standard analysis. And the fundamentals remain strong as commodity exchanges continue to gain customers and have been largely unaffected by the economic slowdown.

Volume shows no signs of flagging and continues to post double-digit monthly growth -- a rare sight these days. The threat of competition from new exchanges -- from an investment bank consortium for example -- would appear now to be lessened. Any plans to create a new exchange would likely be on hold for several years, at least as those banks wrestle with their own balance-sheet issues. They should have little time or capital to invest in creating, from scratch, a quality alternative to proven CME and Nymex products.

While most of the specious premiums in these stocks have dissipated, the compelling reasons for owning these shares have improved. That should make a recipe for a terrific investment.