Market Volatility Spells Profits for This Firm

The stock market has been gyrating wildly in recent months, and the wild ride may be far from over.

That’s great news for Chicago-based CBOE Holdings Inc. (Nasdaq: CBOE). This securities exchange operator is uniquely positioned to benefit from volatile markets.

Shares of CBOE are getting lift from a key technical index: the VIX, which measures market volatility. As the chart below shows, shares have been moving higher in recent weeks, despite a pullback in the broader market. That’s solely due to volatility levels that have not been seen since the financial crisis.

As the VIX appears poised to remain at elevated levels, CBOE’s investors are looking at an attractive profit opportunity.

The Case For Large Near-Term Gains
As the owner of the well-known Chicago Board Options Exchange, CBOE provides the world’s largest market for options contracts on stocks, indexes and exchange-traded products. It directly owns the VIX, as well as the associated options and futures. Key proprietary products also include the highly popular S&P 500 option, the most actively traded index option in the United States.

As volatility rises, demand for options soars because more investors use them to hedge losses, or speculate on specific indexes or securities. Using options, many seek to wager on the direction of volatility itself. The result is a sharp jump in trading volumes and, in turn, profits earned on the transaction fees investors pay for using CBOE’s exchange, and the purchase of  its products.

The stars are aligned for robust near-term results. In the first two months of the third quarter, for example, the average trading volume for VIX options — 815,000 contracts per day — surpassed the second-quarter average by 58%. VIX futures volume rose 44% to an average of 263,000 contracts daily during the same period. CBOE is seeing similar gains in index option trading volumes, which climbed 41% month-over-month in August.

Thus, shareholders can probably expect sharply higher earnings in the third quarter and subsequent quarters if volatility persists. UBS analyst Alex Kramm recently raised his Q3 estimate to $0.69 a share from a prior estimate of $0.54. 

Solid Long-Term Performance
Since CBOE was founded in 1973, investors have become more sophisticated and shown an increased willingness to embrace more complex investment products like options, since these can be used to generate profits in all market climates. As a result, the options arena has been gradually expanding and should keep growing steadily.

CBOE’s financial performance reflects this trend. From 2010 (when the company went public) to 2014, revenue jumped 39% to $607 million and earnings per share more than doubled to $2.19. Unlike many companies, CBOE isn’t showing an over-reliance on share buybacks to increase EPS. At 84 million, the number of company shares outstanding is only about 13% lower than in 2010.
Net margins have been consistently around 30% for several years, up from 22% five years ago and markedly better than the peer group average of 19%. Free cash flow of $208 million in 2014 was nearly twice 2010 levels. CBOE carries no debt. In addition, since the firm initiated a dividend in 2010, the payout has more than quadrupled to $0.92 a share (currently offering a 1.4% yield). A payout ratio below 40% suggests there’s still plenty of room for more dividend increases.

Two upcoming initiatives bode well for continued organic growth. Currently, CBOE only has VIX options that expire monthly. But on October 8, the firm will begin offering weekly expirations, too.

This could significantly boost trading volume, as there’s long been robust demand for shorter-dated VIX options because traders believe these will enhance precision in tracking the VIX index. If the weekly contracts catch on as expected, CBOE could add expirations of less than a week to its VIX options lineup, analysts say.

Another key growth measure: a just-announced partnership with financial markets developer and investment advisor Environmental Financial Products LLC to create the American Financial Exchange, an electronic marketplace for small and mid-sized banks to lend and borrow short-term funds.

With an addressable market of more than 1,700 community and regional banks with total assets of $4.7 trillion, the American Financial Exchange could be another major source of transaction fees for CBOE. The exchange is scheduled to launch sometime in the fourth quarter.

Risks To Consider: Volatility is fickle, often flaring up rapidly only to die down again for long periods. If volatility levels suddenly decrease, CBOE’s near-term results may disappoint.

Action To Take: CBOE is a compelling trade, and I see its stock posting additional strong gains going into management’s next quarterly check-in, scheduled for the end of October or early November. There’s a lot to like about CBOE as a long-term investment, too, as future growth plans foreshadow robust capital gains and brisk dividend growth in the coming years.

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