Exchange-Traded Exchange: Merc IPO Due Thursday

Everyone loves backing a trailblazer, especially if it turns into a successful venture.

And this week investors get a chance to jump aboard a Wall Street trailblazer, as the Chicago Mercantile Exchange, the nation's largest market for trading futures contracts, becomes the first U.S. exchange to sell shares to the public. The Merc's much-anticipated $153 million initial public offering is expected to price late Thursday at around $32.50 a share.

The Merc offers something that most IPOs lacked during the latter stages of the bull market: a profitable company with strong year-over-year revenue growth. This year the Merc is on a pace to generate more profits than the much larger Nasdaq Stock Market, which has been mulling its own IPO for several years now.

Cheap or Dear?

Yet there's reason to believe that the expected asking price for Merc shares might be a little rich when it begins trading on the New York Stock Exchange under the symbol CME.

At $32.50 each, Merc's stock will open trading at price/earnings valuation of 14, based on the exchange's 2001 earnings of $68.3 million, or $2.33 a share. The exchange, which is selling a 15% stake to the public, will boast a market capitalization of roughly $1 billion.

That might sound like a reasonable valuation, considering that shares of Citigroup ( C), the nation's largest financial services firm, trade at a multiple 15 times 2001 earnings. A mid- to high-teens P/E is not uncommon for financial services firms.


Merc IPO Scorecard
Ticker CME
Expected IPO price $32.50 a share
Estimated IPO value $153 million
Total Shares sold to public 4.75 million
Shares sold by exchange 3 million
Shares sold by exchange insiders 1.75 million
Company IPO proceeds $89 million
Tangible book value $12.20 a share
Trailing P/E 14
Source: Merc IPO filing

And the Merc's valuation looks especially good when compared with that of Instinet ( INET), the big electronic trading platform that may be the closest thing in the U.S. to a publicly traded exchange. Instinet's stock trades at a trailing 2001 P/E of 25, even though the stock has fallen 56% this year and the company has reported three straight quarterly losses this year.

Whither Growth?

But while the Merc is on a lot sounder financial footing than Instinet, its valuation could look a bit frothy if the days of fast-paced growth at the 104-year-old exchange are over.

Indeed, to some degree, the past two years have been a bit of a Nasdaq-like bubble for the Merc. Last year, net revenues at the exchange rose 70% to $387.2 million. And for the first nine months of this year, revenue was running 18% ahead of last year's pace.

The big surge in revenue is the result of a huge spike in trading volume on the Merc as recession-wary investors have sought to hedge their bets against changes in interest rates, fluctuations in currency prices and price changes in the stock indices. The Merc, for instance, is one of the world's largest markets for buying and selling eurodollar contracts and futures contracts tied to changes in the value of the S&P 500 or the Nasdaq 100.

But with the Federal Reserve indicating that further interest rate cuts are unlikely, trading activity on the Merc -- especially in futures contracts tied to interest rate changes -- could diminish in the coming year.

Indeed, on that basis, several money managers who invest in financial stocks said they had little interest in Merc IPO. One money manager, who didn't want to be identified, said he's not sold on the concept of buying shares in a publicly traded exchange.

Big Backers

But others say the concerns about the valuation and diminished growth at the Merc are much ado about nothing. Boosters note that the exchange has proven itself to be one of the country's most innovative market trading forums. Indeed, the exchange has come a long way from its early days as a place for Midwest farmers and merchants to buy and sell futures contracts on everything from pork bellies to eggs.

"We happen to love the offering," said David Menlow, president of IPO Financial Network, a market forecasting service. "It's a profitable operation and one of the most innovative exchanges out there in terms of creating products."

Similarly, John Lothian, president of the electronic trading division of the Price Futures Group, a Chicago brokerage firm, said the Merc has an "excellent product mix" and has shown a knack for developing new futures contracts to trade.

There's enough riding on the Merc offering that even critics say there's little reason to believe the IPO won't go forward as planned. The deal is being underwritten and pushed by four big Wall Street firms: Morgan Stanley ( MWD), UBS Warburg, J.P. Morgan Chase ( JPM) and Citigroup. And Wall Street needs the Merc IPO to go off without a hitch if deal-hungry investment bankers have any hope of persuading the Nasdaq and New York Stock Exchange to go forward with their own embryonic IPO plans.

Also rooting hard for the Merc offering is James McNulty, the exchange's chief executive. If the IPO prices at $32.50, McNulty's basket of stock options will be valued at $38.9 million.

These days, that's a commodity a lot of investors would love to get their hands on.

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