This is my final article on the exchange wars. If you missed the first two you can check them out at "Exchange Wars: ICE vs. CME" and "Exchange Wars: Play It Again Sam." A series of comments about these posts that I exchanged with a CME trader provide useful background. Bottom line? My analysis leads to a Mexican standoff. Both merger combinations, ICEBOT as well as CMEBOT, have their strengths and weaknesses. But, it's important to note that BOT shareholders win no matter what.

You also will discover an unexpected new approach to stock valuation. In this approach the impact of market growth, maximum earnings and enterprise marketing productivity are just as important in assessing the quality of a merger as are cost and revenue synergies.

**A CLEAN CASE**

In several ways, the bidding war between CME and ICE for BOT offers an ideal market in which to document the implications of my theory. Why? For one thing, futures exchanges have virtually zero cost of goods sold. What's the marginal cost of an electronic trade made in 100 milliseconds? Virtually zero. Which means overhead costs cannot be loaded onto trading costs. In fact, ICE reports its sales revenues are equal to its gross profit. Also, there are no third-party resellers sandwiched between the customer and the supplier. Finally, the enterprise marketing costs of futures exchanges are enumerated as line items in their income statements. In short, it’s a clean case.

**A TOP DOWN APPROACH**

The first thing you'll notice about this new approach to stock valuation is it begins with market demand, not company sales. The tail-wind factor-- growth in strategic group revenues -- creates a favorable environment for company sales growth. In Step 1 you forecast Strategic Group Revenues.

In Step 2 you calculate each company's maximum earnings market share using incremental analysis. This is a sophisticated form of strategic benchmarking. It equates the incremental cost of a market share point with incremental earnings after enterprise marketing expenses. This is the point where earnings are maximized. For details see my audio slide show on "The Rule of Maximum Earnings." This *Adobe Connect* presentation runs about 14 minutes. [*Click to enlarge the graphics*]

In Step 3 you calculate each company's earnings residual at that share of revenue where they are maximized. This is important. You don't begin with forecast company sales. Rather you begin with forecast strategic group sales and estimate company sales as a product of its maximum earnings market share.

In Step 4 you calculate each company’s Risk-Adjusted Differential (RAD) and Relative Earnings Productivity (REP) for the most recent period. RAD is the difference between a company's share of market value and share of sales revenue, adjusted for volatility. See "Y'all Buckle That Seatbelt." This slide show runs 18 minutes. REP is the difference between a company's actual and maximum earnings. For details see "Competitive Stock Valuation." It runs 13 minutes.

Step 5 you forecast of the strategic group’s combined shareholder value and each company’s share of that value. Finally, given the number of shares outstanding at the end of the forecast period, the present value of lowball, most likely and highball stock prices are calculated.

**ICEBOT's PRICE JUNE 2008**

On the last day of trading in March, 2007 the common stocks of BOT, CME and ICE closed at $181.50, $532.46 and $122.21 respectively. Assuming investors built into these prices their expectations on the value of a merger, the price of ICEBOT was $303.71. The market cap of ICEBOT was $18.0 billion. The number of shares outstanding, adjusted for the merger, was 59.32 million.

If ICEBOT maximized earnings and its rejected suitor responded as I hypothesize below, my lowball forecast (minus 2 sigma) of the present value of its stock in June 2008 is $335. The present value of the expected price is $384 and my highball estimate (plus 2 sigma) has a present value of $430 per share ... assuming no changes in the shares outstanding. The next graphic shows the details in the five step competitive stock valuation process.

Step 1. Strategic group revenues were $729 million on March 31, 2007. That's the sum of each company's sales in Q1-07. I applied a rolling same-quarter year-on growth rate to forecast group revenues. Using the historical rate of 38%, the result in Q2-08 is $1,008 million in group revenues. Note, in this graphic the historical numbers are green and the forecast numbers are yellow.

Step 2. Sales revenues of ICEBOT divided by group revenues gives the merged companies a market share of 51.2% in March, 2007. If ICEBOT maximized earnings over the ensuing five quarters, its market share in June, 2008 would be 56.2%. Achieving this share would require doubling enterprise marketing expenses from $121 to $248 million. This would generate ICEBOT revenues of $567 million: a 52% increase over March, 2007 revenues of $373 million.

Built into this forecast is this assumption: if CME lost its bid management would not take it lying down. Rather, they would attempt to minimize their loss of market share by increasing enterprise marketing expenses at an historical rate equal to that of ICEBOT: about 42%. This move significantly reduces ICEBOT's maximum earnings market share by 360 basis points.

Step 3. ICEBOT's maximum EBITDA reaches $319 million in June, 2008 – a 65% increase over March, 2007 earnings of $194 million.

Step 4. ICEBOT's risk-adjusted differential (RAD) was -0.45 in Q1-07. To put this in perspective, the long run expectation for RAD was zero in a sample of 347 companies in 29 industries over the ten years form 1991 through 2000. See "Marketing's Impact on Firm Value. " Since its RAD was just slightly below the expectation, the ICEBOT merger seemingly did not excite investors all that much. ICEBOT's relative earnings productivity, however, was extraordinary: REP was -2%. What does this mean? ICEBOT produced actual earnings that were only 2% shy of maximum earnings in March, 2007. The historical RAD and REP numbers were assumed be the same in June, 2008.

Step 5. The combined market cap of all three companies was $36.6 billion in Q1-07. A power function (y = 5988.8*Q#^0.8005) fit the 9 quarters of historical data well (R^2 = 0.97). This produced a forecast of the strategic group's market cap in June, 2008 (Q=14) of $49.5 billion.

At the bottom end of the 95% confidence interval, my theory predicts ICEBOT would create 46% of the group's future market value, leading to lowball stock price forecast of $335. At the upper end of the interval ICEBOT would create 63% of the group's market value, leading to a highball price forecast of $430. Since ICE had an historical Beta of 3.2 compared with BOT's Beta of 0.8, I considered this a more risky combination. So I discounted the forecast June, 2008 stock prices at a rate of 3.3% per quarter.

**CMEBOT's PRICE JUNE 2008**

On the last day of trading in March, 2007 the common stocks of BOT, CME and ICE closed at $181.50, $532.46 and $122.21 respectively. Assuming investors built into these prices their expectations on the value of a merger, the price of CMEBOT was $713.96. The market cap of CMEBOT was $28.1 billion. The number of shares outstanding, adjusted for the merger, was 39.42 million.

If CMEBOT maximized earnings, and its rejected suitor responded as I hypothesize below, my lowball forecast (minus 2 sigma) of the present value of its stock is $713 in June 2008. The present value of the expected price is $809 and my highball estimate (plus 2 sigma) has present value of $886 per share ... assuming no changes in the shares outstanding. The next graphic shows the details following the five step competitive stock valuation process.

Step 1. Strategic group revenues were $729 million on March 31, 2007. That's the sum of each company's sales in Q1-07. As in the case of ICEBOT, I applied a rolling same-quarter year-on growth rate to forecast group revenues. Using the historical rate of 38%, the result is $1,008 million group revenues in Q2-08. Note, in this graphic the historical numbers are green and the forecast numbers are yellow.

Step 2. Sales revenues of CMEBOT divided by group revenues gave the merged enterprises a market share of 79.4% in March, 2007. If CMEBOT management maximized earnings over the ensuing five quarters, its June, 2008 market share would fall to 69.7%. Theoretically, the merged companies already were over-sized for the expected revenues in this strategic group. As a result, the enterprise marketing expenses required to maximize earnings barely increase by 4%, from $204 to $213 million. This would generate CMEBOT revenues of $703 million: a 21% increase over March, 2007 revenues of $579 million. Built into this forecast is the assumption that if ICE lost its bid for BOT, management would not take it lying down. Rather they would continue their aggressive pursuit of market position by increasing enterprise marketing expenses at their historical rate of 47%. Compared with a more growth neutral increase of 22%, this move by ICE significantly reduces (by nearly 700 basis points) CMEBOT's maximum earning market share in June, 2008.

Step 3. CMEBOT maximum EBITDA reaches $490 million in June, 2008 – a 73% increase over March, 2007 earnings of $283 million.

Step 4. CMEBOT's risk-adjusted differential (RAD) was -0.61. To put this in perspective, the long run expectation for RAD was zero in a sample of 347 companies in 29 industries over the ten years form 1991 through 2000. See "Marketing's Impact on Firm Value." The CMEBOT merger prospect it seems did not excite investors any more than did ICEBOT's, since its RAD also was slightly below the expectation. CMEBOT's relative earnings productivity, however, was quite extraordinary too: REP was just -8%. What does this mean? CMEBOT produced actual earnings that were only 8% less than maximum earnings in March, 2007. These historical RAD and REP numbers were assumed be the same in June, 2008.

Step 5. The combined market cap of all three companies was $36.6 billion in Q1-07. A power function (y = 5988.8*Q#^0.8005) fit the 9 quarters of historical data well (R^2 = 0.97). This produced a forecast of the strategic group's market cap in June, 2008 (Q=14) of $49.5 billion.

At the bottom end of the 95% confidence interval, my theory predicts CMEBOT would create 59% of the group's future market value, leading to lowball stock price forecasts of $713. At the upper end of the interval CMEBOT would create 75% of the group's market value, leading to a highball price of $886. Since CME had an historical Beta of 1.4 compared with BOT's Beta of 0.8, I considered this a much less risky combination. So I discounted the June, 2008 stock prices at a rate of 1.1% per quarter.

**IT'S THE PROCESS -- NOT THE PRICE**

What's the probability the actual prices of the winning bidder will be bracketed by the nominal lowball and highball prices I forecast for June, 2008? It's non-zero. But I wouldn't say I'm 95% confident in these limits. There's a big difference between statistical confidence and practical confidence. The difference is reflected in the actions management of the winning bidder takes over the next four quarters as well as market devlopments. For example, can you be confident management will maximize earnings? How will investors assess their performance? What might happend to demand for futures exchange services in the next year? How will the rejected suitor respond? And, of course, there's always the possibility that the BOT shareholders will reject both bids on July 9, 2007.

Here’s what I am confident of: the utility of this pricing process. Competitive stock valuation is a valuable supplement to the company cash flow analysis used by the M&A guys. For one simple reason: valuing a stock in the context of a company's simultaneous competition for customers and capital provides a richer perspective on the future. What do you think?

~V

Jeff,

Yes, my analysis did take into consideration the riskiness of the two mergers.

In Step 5 of the ICEBOT PRICE I concluded:

"My theory predicts ICEBOT would create 54% of the group's future market value, leading to lowball and highball stock price forecasts of $335 and $430 respectively. Since ICE had an historical Beta of 3.2 compared with BOT's Beta of 0.8, I considered this a rather risky combination. So I discounted the forecast June, 2008 stock prices are a rate of 3.3% per quarter."

The effect of a 16.5% annual discount rate on the nominal stock price is large. The risk-adjusted Q2-08 lowball price is $335, while the nominal price is $382. The $47 per share difference is 14%. The risk-adjusted highball price is $430, while the nominal price is $522. The $92 per share difference is 22%. The risk is asymmetrically greater on the highball forecast.

Similarly, in Step 5 of the CMEBOT PRICE I concluded:

"My theory predicts the CMEBOT would create 70% of the strategic group's value, leading to my forecast of lowball and highball stock prices of $713 and $886 respectively. Since CME had an historical Beta of 1.4 compared with BOT's Beta of 0.8, I considered this much less risky combination. So I discounted the June, 2008 stock prices at a rate of 1.1% per quarter."

The effect of a 5.5% annual discount rate on the nominal stock price is relatively small. The risk-adjusted Q2-08 lowball price is $713, which the nominal price is $745. The $32 per share difference is just 4%. The risk-adjusted highball price is $886, while the nominal price is $946. The $60 per share difference is 6%.

In short, I judged the riskiness of an ICEBOT merger to be three times greater than a CMEBOT merger. The net-nominal lowball price difference between ICEBOT and CMEBOT is $15. The net-nominal highball price difference is $32. Pretty close to your estimate of a $30 premium.

Yes, the July 9, 2007 vote will be very interesting.

Thanks again for your insightful questions.

~V

Posted by: Victor Cook, Jr., New Orleans, Louisiana | July 03, 2007 at 09:53 AM

Dr. Cook, I have not had the time to go through your new extensive analysis. It doesn't surprise me that it's a standoff.

Does your analysis take into account measures of risk. For example, the CME and CBOT merger would have a minimum of integration risk. An ICE and CBOT merger would have an integration risk at least three standard deviations from the mean of the CME/CBOT.

If ICE is akin to buying a junk bond over high grade corporate, isn't ICE's offer far to low given the amount of risk? Shouldn't it be at least 30 bucks or more? One could conclude that if ICE gets the CBOT, they get them on the cheap.

One thing is for sure, the CBOT cannot afford to go it alone. They have lost more than several key employees, have a gutted IT dept, and have put very little Capex into the company since 2002. They have been managed to be merged. They will have to find another partner if CME is rejected.

It will be an interesting vote July 9th!

Posted by: jeff | July 03, 2007 at 08:15 AM