The Chicago Board Options Exchange goes public this week. It is the last major exchange in the US to go public.  The CBOE missed the going public party by exchanges earlier this decade because of internal wrangling between them and the old Chicago Board of Trade(CBOT).  The CBOE was started in 1973 by the CBOT, and essentially the legal battle was over money.  Since many CBOT members owned membership rights at the CBOE, it took a long time to figure out how to adequately compensate CBOT members,and placate CBOE members.  The outcome was a special dividend and allocation of stock.  Now that the drama is over, the CBOE can go to market and see where the chips fall.

Initially, the chips are going to fall pretty well.  The IPO was supposed to be priced between $25-$29 bucks a share. It is coming out on the high end.  This values the CBOE at around 3 Billion dollars.  The real question is, is this the top valuation or can the stock run up similar to what the other exchanges have done?

I don’t think it can rally explosively, but there is room for some decent appreciation.

First off, market conditions today versus 2002-2003 are far different.  There are prevailing headwinds, not tailwinds to any IPO.  Deleveraging, and the financial crisis have taken the luster off all the exchanges.  The leaders in the group, CME, Nasdaq, NYSE/Euronext, and ICE are floundering, stuck in a trading range.  CBOE will join them.

The CBOE’s most direct competitor, the International Securities Exchange (ISE), was purchased by DeutscheBorse/Eurex.  The purchase price was $2.8 billion.  This will leave CBOE as the only pure options exchange in the marketplace.  Options volume has been growing at the CBOE, and it has been stagnant at ISE.  Other competitors include the NYSE, with their Arca and AMEX platforms, and the Philadelphia Options Exchange (owned by NASDAQ).  CBOE is SEC regulated, so they have a host of other cobbled together competitors like BATS, many dark pools, and internalization of order flow onto prop desks.

Where is CBOE’s strength?  Their volume is 32% of the entire options market.  They are a juggernaut because they own the rights to trade options on contracts like the S+P 100, 500, the Vix, and other contracts that are not fungible with other exchanges.  The CBOE also has a decent electronic trading system.  They are able to trade efficiently.  Currently, they have a hard core group of traders that are loyal and provide needed liquidity.  However, as we have seen at other old line exchanges, that type of loyalty is fleeting.  The newer electronic age black box traders are exchange indifferent.  SEC regulation incents traders to be indifferent as well.  The CBOE also benefits from network effects that exist because for 3 decades, they were the default place to trade options in the world.  These network effects have been tough to break down at other exchanges, no reason why the CBOE won’t continue to enjoy the benefits of them as well.

Where is the CBOE weak?  Really, they aren’t.  However, because of the way the SEC regulates, their business has holes.  It makes no difference if I trade an IBM option at CBOE, ISE, Arca, AMEX or anywhere else.  There is no strategic advantage to trading at CBOE.  If one wants to make a case, CBOE will have higher fixed costs than an exchange like ISE because of it’s trading floor.  However, some in the industry see the trading floor as a strength.  If utilized properly, it becomes an asset.  If used improperly, it is a massive liability. Traditional exchanges have had a hard time figuring out how to mobilize the floor to create value for shareholders.

It also is relatively easy to become an exchange in the options business.  Fungibility creates no desire to be exchange centric.  Intellectual property and contract rights seem to be the only thing the CBOE has going for it.  But, those contracts create a significant amount of CBOE volume.

Calculating the cash flows from the business, CBOE is fully valued at around 3 billion. How can it improve that valuation?  One way it will add to cash flow is by having the exchange own the former seats, and lease them back to anyone that wants to trade.  The seat situation is fuzzy, and one of the reasons there were so many lawsuits.  The CBOE had 930 seats.  The CBOT full members that had purchased a CBOE trading right and kept it current and registered under SEC rules also had rights to trade at the CBOE.  The result of the lawsuit is that the rights of the CBOT members are extinguished, and the CBOE will own all of its rights to trade on the exchange.  Traditionally, the lease price of a CBOE seat was set at 10% of the purchase price of a seat.  However, it is a bit foolish to think that a trader would spend $24,000/mo to trade based on the last sale price of a CBOE seat.  At the height of the internet boom in 1999, the highest seats leased for were $13,000/mo.  The game has changed significantly since then.  Seats lease today for $6000/mo.  Add that $67 million dollar cash flow directly into the CBOE bottom line.  This makes CBOE worth more a little more than $3 Billion.

The other factor in cash flows is 2009.  It was a horrible year.  If I were doing valuation, I would toss that year out.  Volumes and every other number make no sense.  2009 is an outlier because of the crash.  I don’t think it is indicative of future performance unless you believe world economies will collapse or be lackluster for years going forward.  It is hard to imagine that the entire world will follow what Japan has done for the previous 20 years.

The real value in CBOE is acquisition.  They won’t remain a stand alone company.  Who buys them?   There are really only three exchanges out there with either the cash, or the balance sheet to do it.  The natural buyer is CME Group.  It has been aggressive with acquisition, buying the CBOT and NYMEX.  There is a history there, and some synergy because both outfits are in Chicago.  But, with familiarity comes contempt.  The CBOT, CME and CBOE don’t always play nice in the sandbox together. CBOE shareholders will try to bring at least one other exchange into the bidding to drive up the price. Which one will bite?

ICE seems like the least likely best fit.  They are based in Atlanta.  Can ICE realize some sort of electronic synergies?  Perhaps.  ICE trades futures, and futures have options.  If the CBOE system can translate to futures options and explode volume, then it might be worth ICE’s time to have a run at CBOE.  ICE also might see an advantage in having a physical footprint in Chicago, which is the center of worldwide risk management. What can ICE afford to pay?  Their balance sheet is not as good as the CME’s, but it might not matter.  ICE is backed by the investment banks of NYC.  They will pony up cash to keep CME from doing a deal with CBOE, or at least invest enough cash to make the price uncomfortable. Watch ICE.

The NYSE also has a big incentive.  NYSE is the center of the universe for stock trading and has always been unable to figure out how those upstart guys from Chicago got the options business.  Each of their advances into option trading has been a failure.  Now they have a chance to buy the business.  How much will they pay?  There are obvious synergies, plus the chance to integrate the CBOE to the Euronext platform and create a cross Atlantic integrated options market.  NYSE will be a bidder.

Someone will have to pay a premium to win the prize.  That value depends on internally how you assume the numbers will fall to grow your business.  Multiples will be less than pre-crash.  I think the value is different for each exchange. It seems like to me, it’s worth the most to CME and NYSE.  I wouldn’t hazard a guess on the price, but I’d say the probability of it being higher than 4 Billion is more than 1 standard deviation from the mean.

Congrats to the CBOE